How do income and yield differ?
Income is to yield as eggs are to an omelette: an essential ingredient, but not quite the same thing. The income from a portfolio may not equal its yield, and the distributions investors receive may differ still.
What is income?
When investment professionals talk about income, they can be referring to several slightly different concepts. But the most common (and useful) sense of the word is “natural income.”
Natural income is the cash flow generated by a set of assets. In the fund investment world, this is the cash produced by securities in a portfolio, whether it’s in the form of dividends from equities, coupons from bonds or rental income from real estate.
Importantly, natural income does not include cash generated from selling assets, i.e., from liquidating the underlying capital. If the assets in a portfolio are a factory, then income can be thought of as the factory’s output. If you dismantle the factory, then output falls. In the same way, liquidating assets may create a one-off gain, but future income is diminished.
What is yield?
Yield is a measure of return. Again, there are different definitions, but “current yield” is particularly helpful from the perspective of income investing.
Current yield is the percentage measure of income as a proportion of the price of an asset. Because it is based on the current price, as opposed to the face value, it can differ from income measures such as the coupon rate of a bond. The current yield comes into its own as an easy way to compare investments; it’s a quick frame of reference for income today.
Formulas for yield calculations
Dividend yield = Annual divided / Current stock price
Current yield = Annual coupon payment / Current bond price
Gross yield = Annual rent / Purchase price
What is the distribution an investor receives from an income fund?
An investor in the units of an income fund that makes distributions receives a regular payment. This payment comes from the income generated by a fund’s assets, the realized gains on those assets, the actual capital of the assets or a combination of these three. The distribution can be pre-specified, so investors know beforehand what they’re getting, or it can vary, depending on the performance of the underlying assets. It is important that investors know what the distribution is based on, because different kinds of distributions have benefits and drawbacks.
For example, if a fund makes distributions from its capital base, it reduces the potential for future income generation, because the fund will have fewer assets, even though it can make higher payouts in the meantime. Using realized gains for distributions gives up the opportunity to reinvest and build assets for the future in favour of a short-term windfall.