“Money, well, get back. I’m alright, Jack, keep your hands off of my stack.” -Pink Floyd, Money
Your investment portfolio may seem a bit ethereal, as it’s held electronically at a custodian under the guidance of a trusted wealth management team (hopefully TBG), helping to capitalize companies and economic activity throughout the world. But, if you’re distributing income (aka yield) from your portfolio, that can feel much closer to home, contributing directly to your local “stack” of cash (or bank account).
It’s worth spending “some time” on the concept of yield because it can be confusing. And it turns out (in hindsight) “some time” is a precise term meaning an entire edition of Alt Blend, instead of the originally planned four topics I thought we’d cover today. With that in mind, let’s discuss more than you probably ever wanted to know about yield. Here we go!
Right of Way
On the surface, yield is supposed to help us understand how much income to expect from an investment, and it’s expressed simply as a percentage. BUT, it’s based on data over a specific timeframe (e.g., the last 12 months) and the price of the investment at a given time. Thus, if the rate environment has changed, or if the market price of an asset has fluctuated substantially, then that “trailing yield” number could be very different than the level of income the investment will realistically generate going forward. I’ll try to add more insight on this below via some examples. For now, the primary takeaway is that yield may not be what it seems.
On the fixed-income side of investing, there are several different yield measurements, so it’s essential to know which is most relevant in a given situation. Suppose a bond is purchased solely for the coupon rate. In that case, an investor may end up being either pleasantly surprised or disappointed with the total return of the bond (assuming it’s held to maturity). That’s because the coupon rate assumes the bond is trading at par (i.e., for $1000) and doesn’t take into account whether it was purchased at a premium (i.e., bought for more than $1000) or a discount (bought for less than $1000). As a result, there are yield measurements that can provide better insight:
Current Yield (CY): Current yield accounts for bonds trading at a premium or discount by introducing the current bond price into the yield equation. It’s like the “what have you done for me lately?” approach to bond yields. If purchased at a premium, the current yield will be lower than the coupon rate, while buying at a discount will result in a current yield that is higher than the coupon rate.
It’s all just math, but a quick example from Investopedia is as follows: A $1000 bond with a coupon of 6% pays annual interest of $60.00. If the bond is acquired at par ($1000), the yield is 6%. On the other hand, if it’s purchased for $1100, the current yield drops to 5.45% ($60/$1100). Or, if it’s bought for $900, the current yield increases to 6.67% ($60/$900).
Yield to Maturity (YTM): YTM takes the notion of current yield one step further by introducing total return expectations into the equation. When a bond matures, it matures at its par value. In our above example, the bond purchased for $900 will eventually mature at par ($1000); so, not only does that investor start with a higher current yield, but the bond price will gain 11.1% as it matures (i.e., it appreciates from $900 to $1000). YTM combines that fact with interest payments to arrive at one yield number that describes the expected total return of a bond. The premium-bond situation works precisely the opposite way: the investor starts with a lower current yield and loses value (price depreciation) when held to maturity, so YTM will reflect that and will be lower than the current yield. And, if you’re interested in the calculation, the formula is included in the above Investopedia link.
Yield to Worst (YTW): For callable bonds, YTW focuses on lowest possible yield an investor should expect. That’s because the issuer can call the bond (i.e. basically force an early maturity date), which can make the YTM calculation irrelevant. Assuming the bond isn’t going to default, YTW answers the question, “what’s my worst-case return scenario with this bond?” YTM is also known as Yield-to-Call, for obvious reasons. And, of course, here’s a link for additional reference.
Stock, Mutual Fund, and ETF Yields
Stocks, MFs, and ETFs don’t have maturity dates, so “yield” or “dividend yield” is essentially the same as Current Yield – i.e., it’s the percentage that compares recent (or expected) income payments with the market price of the investment. It’s very straightforward on the surface, but digging deeper reveals a handful of nuances we should be aware of:
- It’s important to know what’s behind the yield equation. For instance, in FactSet – a data/analytics system we use – the “yield is calculated by dividing the amount of the Dividends Per Share by the Current Market Price Per Share of the stock. Dividends Per Share are lagged by 45 days by default for the formula” (Source: FactSet Online Assistant). I’m sure that’s a reasonable way to measure dividend yield. Still, I highlighted the “lagged by 45 days” only to show that one can undoubtedly impact dividend yield by altering such parameters. In my experience, dividend yield often looks at the past 12 months of distributions vs. current market price, or it annualizes the most recent dividend (or interest) payment for more of a “projected yield.”
- Building on the first point, the 12 months of “distributions” may only include regular dividends but may also include one-time payments, like special dividends from companies and/or capital gains distributions from funds. If those one-time payments were higher than usual over the past year, then the yield number may be artificially inflated until enough time passes for that payment to drop out of the equation.
- If we find ourselves in a falling rate environment, it may be difficult (or mathematically impossible) for a fund manager (or bond index within an ETF) to replicate the same level of yield from the past year. As with point #2, it results in a “phantom yield” that investors won’t receive again. However, in a rising rate environment, this same idea could result in an unexpectedly higher yield, and that’s a good thing, as long as the price of our investment is stable (see point #4).
- Buying an investment with a high yield isn’t necessarily a good thing if the price of that investment is continuously falling. If you’re receiving distributions from an investment that keeps declining in value, you’re essentially just spending down your assets. Instead, if the value of your investment stays level or even increases while you’re collecting income payments, then that’s real We touched on this concept back about a year ago (in Portfolio Longevity Part 1: Weight? There’s More) by using a well-known high-yield ETF as an example.
- Keep in mind that yield depends on price! If you notice a stock or fund with an above-average yield, then it may be because the price has recently declined. Dividends are paid in dollars and cents per share (not as a percentage of value), so – similar to the bond examples we started with – given that the dividend dollar amount is constant, the yield percentage will fluctuate based on the market price of the stock or fund. IF the investment is a good one for the long-term, then a higher yield could mean it’s a good time to buy because of a temporarily depressed shareprice.
On the other hand, if a yield has declined for a stock you’ve owned for a while, it’s not necessarily a bad thing; if the dividend has stayed the same (or GROWN, which we love at TBG), but the shareprice has appreciated more quickly than the dividend, then yield percentage will decline. In dollars-and-cents terms, the dividend amount may still be the same (or higher) than it was – so your income is still the same (or higher) than it was when the stock was purchased – and the company (especially a dividend-growth company) will ideally try to raise the dividend to help keep up with the shareprice appreciation over time. That could be worth waiting for.
Now that we’re fluent in the nuances of yield calculations, Alts will be pretty straightforward. Yields for open-ended funds (daily liquid, interval mutual funds, interval private funds, hedge funds) will be just like we discussed in the above section. Compared to daily-liquid funds, private funds can use more leverage to help increase yield (and, as we know, more leverage = more risk), so it’s arguably even more important to understand how the income is generated.
Specific to drawdown funds, yield is quoted based on the amount invested in the fund at a given time (that technically applies to all investments, but bear with me). If the yield is very high when only a small amount of capital has been called but then declines substantially once the fund is fully invested, then that’s (all else being equal) less attractive than a fund that can maintain a consistently high yield throughout its lifecycle.
Along those same lines, the phrase “cash-on-cash yield” is often used when discussing real estate investments. A simple way to think about this is by asking the question, “How much cash am I getting on the cash I invested?” If you invested $10.00, and you’re getting $1.00/year in income, then that’s a 10% cash-on-cash yield. While that sounds good, it ignores how much leverage is involved to juice the yield up to 10%. For example, say real estate manager takes your $10.00 and borrows another $10.00 to buy $20.00 of assets. If those $20.00 of assets generate the $1.00 of income, the cashflow of the underlying asset is only 5% ($1.00/$20.00). However, the yield on the $10.00 investment amount (and YOUR yield) is 10%. And that’s cash-on-cash yield.
I know what you’re thinking: Hey, Steve – doesn’t that mean “cash-on-cash yield” is pretty much the same thing as (regular) “yield” from the end-investor’s perspective? Yes! But it’s cool jargon that private real estate managers use, so now you can go impress your friends.
Until next time, this is the end of Alt Blend.
Thanks for reading,