What is a Yield Advantage?
Yield advantage is the difference between yields on two different securities issued by the same company. It is the additional amount an investor can expect to earn if he or she chooses one security over another.
How Does a Yield Advantage Work?
The formula for yield advantage is:
Yield Advantage = Yield on Security A - Yield on Security B
Let's assume Company XYZ has two types of securities outstanding: 10,000,000 shares of common stock that pay $0.50 a year in dividends and $20,000,000 in convertible bonds that pay 7% interest per year (or $70 per $1,000 bond). The bonds are convertible into common stock.
If the stock is trading at $20 per share and the bonds are trading at $1,200 per bond, we first calculate the yields on each security:
Stock: $0.50 / $20 = 0.025 or 2.5%
Convertible Bonds: $70 / $1,200 = 0.0583 or 5.83%
Using the formula above, we can calculate that the yield advantage for the convertible bonds is: 5.83 - 2.5 = 3.33%
In this case, investors in Company XYZ earn a much higher yield on the convertible bonds than on the common shares.
Why Does a Yield Advantage Matter?
Yield advantage is helpful in evaluating a company's financial structure decisions. In some instances, it is also an indicator of how closely a company is monitoring that financial structure in an effort to preserve cash.
It is important to note, however, that in this example and countless others, simply "switching" to a security with a higher dividend yield is not always an easy decision.