Yield vs. Total Return: How They Are Different

Those who have struggled to grow their money in the low interest rate environment over the past decade have mainly been retirees and others who invest for income. Money market interest continues to be virtually non-existent and yields on other traditional income vehicles such as CDs remain low.

As these investors seek ways to meet their income needs, it is helpful for financial advisors to educate their clients on the concepts of both yield and total return. 

Yield is defined as the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.

By this definition, yield would imply cash thrown off by the investment with no invasion of principal. In some cases this may not be true. As an example, some closed-end funds (CEF) will actually use the return of investor’s principal to keep their distributions at the desired level. Investors in CEFs should be aware whether their fund is engaging in this practice and also what the possible implications are.

Investors focusing strictly on yield are typically looking to preserve principal and allow that principal to generate income. Growth is often a secondary investing consideration. This is especially true of fixed income vehicles such as CDs, bonds and depository accounts.

Dividend-paying stocks have become a popular vehicle for their yields on corporate earnings, which in many cases are higher than a typical fixed income investment.

Total return includes interest, capital gains, dividends and distributions realized over a given period of time.

In other words, total return on an investment or a portfolio includes both income and appreciation.

Total return = interest + dividends + capital appreciation (or – capital loss).

Total return investors typically focus on the growth in their portfolio over time. They will take distributions as needed from a combination of the income generated from the yield on various holdings and the price appreciation of certain securities. While total return investors do not want to see the overall value of their portfolio diminished, preservation of capital is not their main investment objective.

The idea of being an income investor and living off of the yield from your investments with no erosion of principal is not always realistic. Some typically tame income-producing vehicles such as U.S. Treasurys have produced losses in certain years.

While individual holdings, mutual funds or ETFs in regularly tame asset classes may continue to throw off cash based upon their yield, investors may find themselves worse off if the decline in value is greater than the income yield over time, defeating the their capital preservation strategy.

Funds and ETFs in these asset classes can be valid investments, but those seeking yield should understand the risks involved. Again, the positive impact of a decent yield can be wiped out quickly in a steep market decline impacting these asset classes. 

Many financial publications and advisors tout the benefits of investing in dividend-paying stocks. Further, they often recommend these stocks as a substitute for typical income producing vehicles. While dividend paying stocks have many benefits, investors need to understand that they are still stocks and are subject to the risks faced by investing in stocks. This also is true when investing in mutual funds and ETFs that invest in dividend paying stocks.

High-yield bonds are another vehicle used by investors reaching for yield — also known as junk bonds. These are below-investment grade bonds and many of the issuers are companies in trouble or at an elevated risk of getting into financial trouble. High-yield bonds are often purchased by individual investors through a mutual fund or an ETF. This minimizes the risk of default as the impact of any one issue defaulting is spread among the fund’s holdings.

There is no reason that generating investment income and investing with your portfolio’s total return in mind need to be mutually exclusive. Depending upon the needs and situation of a given investor, a well-balanced portfolio can include both income-generating investments and those with the potential for price appreciation.

One major benefit of using a total return approach is the ability to spread your portfolio across a wider variety of asset classes that can actually reduce overall portfolio risk. This has several benefits for investors. It allows them to control where the income producing components of their portfolio are held. For example, they can hold income generating vehicles in tax-deferred accounts and those geared towards price appreciation in taxable accounts.

This approach also allows investors to determine which holdings they will tap for their cash flow needs. For example, after a period of solid market returns, it might make sense to take some long-term capital gains as part of the rebalancing process.

(For related reading, see Corporate High-Yield Bonds vs. Equities.)

Investors should understand the key differences between yield and total return. Financial advisors can help their clients in doing this and help ensure that portfolios are constructed to meet income generating needs while providing a level of growth for the future.

(For related reading, see Key Differences Between ETFs and Mutual Funds.)