Returns, Dividends, and Yield

An investment pays you in several forms, and the exam wants you to name each one. It also wants the dividend dates in order and the right yield measure for each question.

Where your return comes from

Four things pay you, and the exam names all four.

• Interest: what a debt security pays, such as a bond's coupon.
• Dividends: what a company or a fund pays out of earnings, at the board of directors' discretion.
• Capital gains: the rise in the price of what you own.
• Return of capital: a distribution that hands back part of your own money rather than earnings.

A gain is realized when you sell. While you hold the position it is unrealized, existing only on paper. That split decides the tax: a realized gain is taxed, an unrealized one is not.

Return of capital lowers your cost basis instead of counting as income. No tax is due when it arrives, and a larger gain shows up at sale.

Cash dividends and stock dividends

A cash dividend pays money per share. Own 300 shares of a $40 stock paying $0.50 a quarter and you collect $600 a year. You owe tax on it in the year you receive it.

A stock dividend pays extra shares instead of money. Every holder gets the same proportion, so your slice of the company stays the same size. Own 100 shares bought at $40, take a 10% stock dividend, and you hold 110 shares worth the same $4,000. The basis per share drops from $40 to $36.36, and the tax waits until you sell.

The four dividend dates

The board declares a dividend on the declaration date and announces the amount plus the dates that follow.

• Record date: the day the company checks its books. Whoever owns the shares that day receives the dividend.
• Ex-dividend date, or ex-date: the first day the stock trades without the dividend attached. Buy on the ex-date and the seller keeps it.
• Payable date: the day the money reaches shareholders, a few weeks after the record date.

Settlement is T+1, so a trade settles one business day after the trade date. Buy the business day before the record date and you settle on the record date, which makes you an owner of record. Buy on the record date and you settle a day late. So the ex-date and the record date fall on the same business day.

Before you buy a stock for its dividend, check the ex-date. Say the record date is Friday, April 4. The ex-date is that same Friday. Buy on Thursday and the dividend is yours; buy on Friday and it belongs to the seller.

Older study material puts the ex-date one business day before the record date, which was the T+2 rule. On the ex-date the stock opens lower by roughly the dividend, because the buyer no longer gets that cash.

Measuring the return

Yield states income as a percent of price.

• Current yield is annual income divided by the current market price. That $40 stock paying $2.00 a year yields 5%, a figure also called the dividend yield.
• Yield to maturity (YTM) is the total return on a bond held to maturity. It counts the coupons plus the gain or loss between your price and par.
• Yield to call (YTC) runs the same calculation to the call date and the call price.

Buy a bond at a discount and every yield sits above the coupon rate, with YTC highest. A premium bond reverses the order.

Total return counts everything: income plus price change, divided by what you paid. Buy that stock at $40, collect $2.00 in dividends, and watch it reach $43. That is $5 on $40, a 12.5% total return, where the yield alone showed 5%.

A basis point is one hundredth of one percent. A yield moving from 4.25% to 4.50% has moved 25 basis points.

Cost basis

Cost basis is what you paid for a position, including commissions and sales charges. Subtract it from your sale proceeds to get the gain or loss you report.

Three things change your basis after you buy:

• Reinvested dividends buy more shares, and what you pay adds to your basis. You already paid tax on those dividends.
• A return of capital distribution lowers your basis.
• A stock dividend spreads the same basis across more shares.

When you sell part of a position, the shares you pick decide the gain. First in, first out (FIFO) is the default, so the oldest shares go first. You may instead identify the exact shares at sale, and mutual fund holders may use average cost. Your firm reports the basis of covered securities to the IRS on Form 1099-B.

Benchmarks and indices

An index measures the performance of a basket of securities picked to represent a market or part of one. You cannot invest in an index directly, though an index fund tracks one.

Four indices show up most often:

• The Dow Jones Industrial Average (DJIA): 30 large US companies, weighted by price.
• The S&P 500: 500 large US companies, weighted by market capitalization.
• The Nasdaq Composite: almost every Nasdaq-listed stock, so it leans toward technology.
• The Russell 2000: 2,000 smaller companies, the small-cap benchmark.

A benchmark is the index you measure a portfolio against, so match it to what the portfolio holds. Judge a small-cap fund against the Russell 2000, not the DJIA.

How this gets tested

Most questions hand you one fact and want the right label or date.

"A customer wants the dividend. What is the last day to buy?" The business day before the ex-date, which under T+1 is the day before the record date.

"Which measure captures both income and price change?" Total return. Current yield counts the income alone.

"A fund pays a return of capital." No tax arrives now, and the cost basis falls.