If you’re someone who enjoys following financial news, you’ve probably come across the term “yield.” A little over a month ago, the US 10-year treasury yield crossed 3% for the first time in 4 years and the news cycles made a big deal about it. But what does “yield” even mean? Here’s a quick refresher.
Yield has to do with the amount of income an investment is generating, whether it comes from interest or dividends that are paid out to an investor who holds a particular security. The yield is expressed as a percentage of either an investments current market value or face value. You can think of it as the income that an investment yields. For simplification's sake, let’s say we have an investment worth $100 that has generated $8 this year. The yield on that investment is 8% (8/100 = .08 or 8%).
Yields can be calculated on all kinds of investments including stocks, but we hear about them most often regarding bonds. A few different types of yields that are helpful to know are the current yield which is the bond interest rate as a percentage of the current price of the bond, and the yield-to-maturity which is an estimate of what an investor will receive if a bond is held to maturity.
Like the inverse relationship between bond prices and interest rates, there is also an inverse relationship between bond prices and yield (which is linked to interest rates). This is because when rates rise, in order to make bond yields attractive enough to match current rates, the price must fall. Remember our hypothetical investment that was yielding 8%. Let’s say that the yield on newly issued bonds of a similar nature rise to 10%. Why would you want 8% when you can get 10%? The income being generated is the same. Therefore, in order to make that first bond’s yield more attractive, the price has to fall from $100 to $80. Now the $8 yield on $80 equals 10% (8/80 = .1 or 10%). This sounds like a bad thing. Prices are falling! But here’s the catch: while prices are falling in the near term, rates are also increasing, meaning that going forward if you purchase a new investment at $100 it will pay $10 instead of $8.
If you’d like to learn more about the basics of the financial markets, we invite you to poke around our blog.