By guest contributor, Marc Hollenstein, Analyst, Atchison Consultants
When debt securities with a fixed coupon are held to maturity, their yield to maturity is equal to the income streams received in cash plus or minus any capital gain or loss. For instance, if a debt issuer offers a yield of 10% on a $100 bond trading at face value, the creditors can count on interest payments of $10 every year until maturity of the bond.
Unless the debtor defaults, the certainty of the cash flow will be of particular importance to creditors, such as retirees who are dependent on income for daily living expenses. This certainty will also be important to entities which have to satisfy certain income/distribution requirements, such as insurance companies.
Income from equities is also commonly disclosed as a percentage yield and this yield is displayed in newspapers, brokers’ reports and in new issue applications. This figure is known as the dividend yield and it is calculated by expressing the sum of dividends which have been paid in the previous 12 months as a proportion of the current share price.
However, dividend yields are not the same as coupons. Investors may be misled if they fall for a fundamental human fallacy in which past ratios are mistaken for future certainties. An investor may confuse a dividend yield with a cash payout. After all, dividends are paid at the discretion of a company’s directors, so the amount paid in one period may not be the same as the amount paid in the next period.
The problem often starts when people see a high yield and consequently form the assumption that the disclosed yield will eventually convert to actual cash payment.
If, for instance, dividend distributions in dollar terms increased by 50%, then one would rightly expect for every one dollar received during the previous distribution cycle, this time around it would be $1.50. Alternatively, if the dividend yield increases by 50%, one’s expectation of a payout of $1.50 will most likely be false.
A financial yield is calculated as a proportion of the income of the asset’s price. Hence, one’s expectation of a payout of $1.50 due to a 50% increase in the dividend yield would only be true if the asset price didn’t change from one distribution cycle to another.