Gross redemption yield and net redemption yield are two financial calculations that can help you calculate the rate of return on your investments. Typically, redemption yields are used in debt-based investments -- such as bonds, savings accounts and certificates of deposit -- that represent an investment in the debt of a third party, normally a bank. Understanding the rate of return can help you predict the viability of the debt instrument and to decide if a particular investment is worth it.
Debt-Based Investment Instruments
Redemption yields on debt-based investment requires the investor to understand some basic terminology. Simply put, a debt-based instrument means you are lending the issuer money to fund its operations. When you "buy" a bank bond, for instance, you are lending the bank money so it can stay in business. In exchange for lending the bank money for a certain number of years, the bank will pay you interest. This is the return on your investment. For most debt-based instruments, the return is a guaranteed percentage, but it may also include a variable amount that fluctuates with the market. On a 10-year bond, for example, you might be guaranteed a 5 percent return on top of your initial investment. At the end of the 10 years, you get your original investment back plus the 5 percent.
Gross Redemption Yield
The basic calculation for determining rate of return on debt-based investments is gross redemption yield, sometimes called yield to maturity. This is the estimated rate of return you can expect to receive on the principal of your investment if you keep the investment until its maturity date. If you hold a bond for the full term, for instance, the gross redemption yield would be the actual growth of the investment over the whole term. Say you invest $100 in a 10-year bond. At the end of 10 years, you are expected to be returned $115 -- $100 from the principal and $15 in interest. This equates to 15 percent return total, or 1.5 percent per annum. Gross redemption does not take into account any fees or taxes you might pay on the interest earned.
Net Redemption Yield
A more advanced calculation is net redemption yield. This takes into account the tax you pay each year on the investment. To calculate the net redemption yield, start with the amount of money you'll be returned at the end of the term -- $115 for example. From that amount, deduct the estimated taxes and fees you are expected to pay. If the taxes are 5 percent, for instance, you would deduct $5.75 to yield $109.25. This is the same as saying you've earned a net of $9.25 after all the taxes have been paid. In other words, that's a 9.25 percent net return.
You can calculate both gross redemption and net redemption yields either before you invest in a particular instrument or nearer the instrument's maturity date. If you do the calculations before investing, you should keep in mind that this will only give you an estimate of the actual return. It is possible to predict the return, especially if you've been guaranteed a set amount, but you won't be able to accurately predict the changes in market conditions or tax rates over the course of the instrument's full term. Municipal bonds are tax free, so a net redemption calculation is frivolous with these instruments.
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