Terminology for investment income
Over the past 5 years, investors have been drawn to income-producing investments. Any investment with the word ‘income’ enjoyed tremendous sales success like income trusts, dividend income equities, and income mutual funds. Even investors who did not need income from their investment portfolios bought into the euphoria because at the end of the day, past performance sells.
As a result of this massive explosion of income-producing investments, investing for income has become more complicated, especially with terminology. It has become increasingly important to revisit the definitions of three important words in income investing – return, income, and yield.
Back in the days of the GIC, these three words were used interchangeably and they pretty much meant the same thing. The rate of return on a GIC was the same as the income and the yield. Today, return, yield and income no longer mean the same thing.
Rate of return
The rate of return is the actual return of the investment and in the world of a non-guaranteed investment like mutual funds, a return is usually expressed in the past tense. For example, we might say that a mutual fund returned 8% last year, which means if you started with $1000, then that investment should be worth $1080. The reason I say it is past tense is that people often mistakenly think that past tense means future returns. Remember that past performance is no indication of future performance.
Let’s switch gears to yield. Often, the industry looks at the yield on the investment as the cash flow that is being paid out to the investor. For example, you can have that same mutual fund that made an 8% return provide a yield of only 6%. A 6% yield means that the investor was paid $60 over the year on a $1000 investment. Since the return was 2% accrued higher, it is reflected in capital appreciation. In other words that $1000 grew to $1020 and $60 was paid to the investor.
The problem is I’ve seen some investments promote income yields in excess of 10% where investors mistakenly think that this investment is going to give them a rate of return of at least 10% only to find out later that there are times the income they are getting is simply a repayment of their own capital. For example, if the yield was 10% and the rate of return was only 8%, this means the investor was paid $100 on a $1000 investment and now the investment was only worth $980. Of the $100 payout to the investor, $80 was the profit and $20 was part of the capital.
Are you confused yet? Let me complicate it more with income. Income often refers to more of the taxable implication of the cashflow. Sometimes yield and cash flow are the same but today more and more investments are trying to be more tax-efficient by differentiating cashflow from yield.
Let’s continue on the same mutual fund that has a rate of return of 8% and a yield of 6.0%. Some mutual funds intentionally payout 6% as tax-efficiently as possible. For example, you might find you will pay little to no tax on the 6% cashflow. Now you have an investment that had a return of 8%, paying a yield of 6% but only attracting a little income tax on the yield.
The point here is that it has become more confusing but investors really need to make sure they understand how investments work before they buy especially when there are income and yield being produced from these investments. Even these explanations are not universally accepted. Take the time to understand the differences in terminology in a more complicated world. Make sure you don’t mistakenly think you are getting some perceived return when someone else is talking about yield, cashflow or income.