If the average gross dividend yield offered by equities is 3% per annum and the gross guaranteed annual yield offered by long-term government bonds (assumed to be risk free) is 2% per annum, the yield gap at this time is:

• A. -1% per annum
• B. +2% per annum
• C. +5% per annum
• D. +1% per annum

Answer: (D)

The yield gap measures the extra return investors expect from holding equities over a risk-free government bond. It’s the difference between the equity yield and the risk-free yield.

Here, equities offer 3% gross dividend yield and long-term government bonds offer 2% gross yield. The gap is 3% − 2% = 1% per year. So the yield gap is +1% per annum.

A positive gap means equities are delivering about one percentage point more yield to compensate for the additional risk. (If the numbers were reversed, the gap would be negative; if the equity yield were higher by more than 1%, the gap would be larger, and so on.) These yields are gross, so taxes or fees could change the net picture.