Yield Gap
The gap between the earnings received via stocks in the form of profits or dividends and the government-issued bonds.
What is a Yield Gap?
The Yield gap is the gap between the earnings received via stocks in the form of profits or dividends and the government-issued bonds, for example, Treasury bills.
The yield ratio describes the ratio between the earnings provided via stock and those provided via a government-issued bond. Both measured relatively, which is either in percentage or ratio.
The yield gap can also be calculated for bonds provided by companies and their returns. This helps an investor assess the risk associated with the bond or the stock and the relative return compared to a "risk-free rate" issued by a government-issued bond.
Remember that not all government-issued bonds are risk-free; some carry a default risk, which can be negated by subtracting the insurance cost or via the ratings of the underlying bond.
The yield gap can also determine whether a stock is over or underpriced compared to the government bond. A smaller yield gap represents smaller comparative returns, indicating overpriced equity. Conversely, a higher yield gap indicates underpriced equity.
Suppose the return on the government-issued bond exceeds the return on the underlying equity or the bond. In that case, the net yield gap is negative, also referred to as the reverse yield gap.
The magnitude of the reverse yield gap is the total difference between the returns of each asset under consideration, that is, government-issued bonds and equity.
Key Takeaways
- The yield gap is a representation of the difference between earnings through a stock or a bond and government-issued bonds (Treasury bonds/bills)
- It describes the return of a stock or bond and its risk.
- The yield gap can be measured in different formats, either in the percentage of the ratio of the returns or the absolute difference between the returns of the underlying stock and government-issued bond.
The yield on different assets
A yield gap is an essential tool when trying to assess an asset. It helps visualize the risk carried by an asset for better investments. However, the yield gap can sometimes be misleading and misinterpreted for discount rate/ Cost of equity.
Remember that government-issued bonds sometimes carry default risk, especially in high-inflation countries where risk-free rates can be lower than the return a government bond offers.
Let us look at different types of assets we can evaluate using yield gap:
Equity
Yield for equity can be calculated in two major ways: the ratio of earnings from the stock and the capital invested.
The first one uses the company's earnings per share (EPS) and the current market price for the respective stock. Next, it gives a percentage of total returns on the capital invested.
Example:
Company A files an annual earnings report of 1,000,000$—total shares outstanding of 500,000 and making 2$ per share. Let's say the market price of the share is 100$ giving the yield of 2/100 or 2%.
Remember that filings report different timeframes, quarterly for three months and annual for a year.
The second one uses the dividend as a way of measuring earnings. Yield measured using dividends, also known as dividend yield, uses the ratio of dividends offered by a company per share to the market value of the respective share.
Bond
The yield on the bond is the ratio of returns made on a bond and its face value. Analysts can also use the bond's market value to calculate the net yield.
In many cases, a certain return is expected compared to the investment risk, called Required Yield.
If the yield is calculated using the interest paid by the issuer and the face value of a bond, it is called Nominal Yield.
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