Yield to Maturity vs. Coupon Rate: An Overview
When an investor researches available options for a bond investment they will review two vital pieces of information, the yield to maturity (YTM) and the coupon rate. Bonds are fixed-income investments that many investors use in retirement and other savings accounts. These securities are a low-risk option that generally has a rate of return slightly higher than a standard savings account.
The yield to maturity (YTM) is the estimated annual rate of return for a bond assuming that the investor holds the asset until its maturity date.
The coupon rate is the earnings an investor can expect to receive from holding a particular bond. To complicate things the coupon rate is also known as the yield from the fixed-income product.
Generally, a bond investor is more likely to base a decision on an instrument's yield to maturity than on its coupon rate.
Comparing Yield To Maturity And The Coupon Rate
- The yield to maturity (YTM) is the estimated annual rate of return for a bond assuming that the investor holds the asset until its maturity date.
- The coupon rate is the earnings an investor can expect to receive from holding a particular bond.
- At the time it is purchased, a bond's yield to maturity and coupon rate are the same.
- The bond's yield to maturity rises or falls depending on its market value and how many payments remain to be made.
Yield to Maturity
As mentioned earlier, the yield to maturity (YTM) is an estimated rate of return that an investor can expect from a bond. This value assumes that you hold the bond until its maturity date. It is also assumed that all interest payments received are reinvested at the same interest rate as the bond itself. Thus, yield to maturity includes the coupon rate within its calculation. YTM is also known as the redemption yield.
A bond's yield can be expressed as the effective rate of return based on the actual market value of the bond. At face value, usually, when the bond is first issued, the coupon rate and the yield are the same numbers. However, as interest rates rise or fall the coupon rate offered by the government or corporation may be higher or lower. This change in interest rates will cause the face/par value of the bond to change as it tries to stay competitive with other offerings. In this way, yield and price are inversely proportional or move in equal but opposite directions.
The coupon rate or yield of a bond is the amount that an investor can expect to receive as they hold the bond. Coupon rates are fixed when the government or corporation issue the bond. Calculation of the coupon rate is from the yearly amount of interest based on the face or par value of the security.
Suppose you purchase an IBM Corp. bond with a $1,000 face value that is issued with semiannual payments of $10 each. To calculate the bond's coupon rate, divide the total annual interest payments by the face value. In this case, the total annual interest payment equals $10 x 2 = $20. The annual coupon rate for IBM bond is, therefore, $20/$1,000, or 2%.
While the coupon rate of a bond is fixed, the par or face value may change. No matter what price the bond trades for, the interest payments will always be $20 per year. For example, if interest rates go up, driving the price of IBM's bond down to $980, the 2% coupon on the bond will remain unchanged. But, when the asset sells for more than their face value it sells at a premium. Likewise, when they sell for less than the face value they sell at a discount.
To an individual bond investor, the coupon payment is the source of bond profit. To the bond trader, there is the potential gain or loss generated by variations in market price. The yield to maturity calculation incorporates the potential gains or losses generated by those market price changes.
If an investor purchases a bond at par value or face value, the yield to maturity is equal to its coupon rate. If the investor purchases the bond at a discount, its yield to maturity will be higher than its coupon rate. A bond purchased at a premium will have a yield to maturity that is lower than its coupon rate.
YTM represents the average return of the bond over its remaining lifetime. Calculations apply a single discount rate to future payments creating a present value that will be about equivalent to the bond's price. In this way, the time until maturity, coupon rate, current price, and the difference between price and face value all are considered.