When an investment advisor quotes a yield of, say, 5 per cent for a security, most people would think that they would actually receive a cash return of 5 per cent a year if they invest in it.

In some cases, they would, but in others they wouldn’t. That is because the term “yield” can mean a dozen or more different things in investing.

The yield being cited could be the coupon yield, semi-annual yield, annual yield, current yield, or cash-on-cash yield, among others. It could be cited on a pre-tax or after-tax basis.

It’s important to know which, since not only would that determine how attractive the investment really is, but how close to the quoted yield the actual return to the investor would be.

For bonds, the standard usage of the word is for the “semi-annual yield to maturity.” The calculation assumes that bonds pay interest every six months and that each coupon payment is reinvested at the stated semi-annual yield until the bond matures.

For example, the Government of Canada bonds with a coupon of 5.5 per cent and a maturity date of June 1, 2009 were quoted at the close of trading on December 19, 2003 at a price of $106.65. Anyone investing at that price would pay $106.65, receive coupon payments of $2.75 every June 1 and December 1 until maturity, and receive a principal payment of $100 at maturity.

The calculated semi-annual yield to maturity for this bond was 4.12 per cent. This was the number reported in the bond tables in newspaper the next day.

Note that the yield was lower than the “coupon yield” of 5.5 per cent because the yield to maturity calculation takes into account that the principal returned at maturity in this case will be lower than the price paid.

Note also that the semi-annual yield to maturity was lower than what is known as the “current yield,” which is simply the coupon percentage (5.5) divided by the price (106.65), which in this example is 5.15 per cent. The “current yield” would be misleading in this example because, like the “coupon yield,” it does not account for the fact that the investor would (upon maturity of the bond) receive back less than the amount originally invested.

But while the semi-annual yield to maturity calculation is more accurate, it still doesn’t necessarily represent what an investor would get as a cash return.

The semi-annual yield to maturity calculation, which is complicated and can be done only on special financial calculators, would assume in the above example that all coupon payments received every six months until maturity will be re-invested at 4.12 per cent.

But what are the chances of this taking place?. For instance, if interest rates fall in the future, the re-investment rate of interest may be somewhat lower, such as 2 or 3 per cent. So the actual dollar return to the investor would end up being lower than 4.12 per cent. Similarly, if the general level of interest rates rises, the actual return could be higher than 4.12 per cent.

Also, note that the 4.12 per cent yield to maturity is for a five-year bond. Five-year bonds generally in the marketplace have a higher yield than short-term bonds and treasury bills. As the bond approaches maturity, the short-term yields available for re-investment of the coupons would likely be lower than the cited semi-annual yield to maturity.

Some bonds and most financial institution GICs (which are like a bond) pay interest on an annual basis and an “annual yield” is cited for them. However, a 5 per cent annual yield to maturity is not equivalent to a 5 per cent semi-annual yield to maturity. For a five-year bond paying a 5 per cent coupon annually, the semi-annual yield would be more like 4.75 per cent because the semi-annual yield calculation assumes a twice-a-year coupon payment that can be effectively re-invested sooner and for greater total return.

Investment advisors sometimes cite the annual yield for a bond instead of the semi-annual yield because the annual yield is higher and looks better to their clients.

With respect to the impact of taxes, yields are normally cited on a pre-tax basis. If the security is held outside of a registered plan like an RRSP, the actual after-tax return would be lower. How much lower would depend on the investor’s marginal tax rate. The higher the marginal tax rate, the lower the after-tax yield.

The tax situation is also important for income trusts. Monthly cash distributions are normally split into taxable income and return of capital. Held outside an RRSP, a trust’s taxable income is taxed at the investor’s marginal rate, while the payment of tax is deferred on the return-of-capital portion until the trust units are sold, at which time it would be subject to a capital gains rate (half of the marginal rate).

As for the yield calculation, income trusts are normally quoted on a pre-tax “cash-on-cash yield” basis. This usually involves taking the amount of cash distributions per unit over the past 12 months and dividing it by the quoted price. If the distributions over the past year were $1 per unit and the price of each unit is $10, the “cash-on-cash yield” is 10 per cent.

But, as with bonds, the cited yield can be something different than it seems and it can get confusing. Sometimes the expected cash distribution for the current or coming year is used in the calculation instead of the past year’s distribution. Also, some trusts in their news releases take the distribution for the latest month and annualize it. Some use the original price at issue, rather than the current price, to calculate a yield. Again, depending on what is paid in the future, the actual return to an investor could be different than what is being cited.

The various meanings of “yield” don’t end here. The yields for preferred shares and callable bonds can depend on whether the calculation is to the call or maturity dates. Real yields on real return bonds are a special case.

What investors should take from this discussion is that cited yield is not always what it seems and when it comes to investing in a security, it is important to dig deeper.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

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©2003 Wayne Cheveldayoff