Bond Yield to Maturity vs. Coupon Rate: An Overview
A bond's coupon rate is the amount of interest income earned on the bond each year based on its face value. Its yield to maturity (YTM) is the estimated rate of return assuming that it is held until its maturity date. Thus, yield to maturity includes the coupon rate within its calculation.
Generally, a bond investor is more likely to make a decision based on an instrument's yield to maturity than on its coupon rate.
Calculating the Coupon Rate
Suppose you purchase an IBM Corp. bond with a $1,000 face value that is issued with semi-annual 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%.
That coupon rate is fixed. 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.
Comparing Yield To Maturity And The Coupon Rate
Understanding Bond 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, the coupon rate and the yield are the same numbers.
But say that interest rates fall and the IBM Corp. bond is sold at a $100 premium. The bond's yield is now equal to $20 ÷ $1,100, or 1.82%.
If interest rates increased, the price of that bond might fall to $980. The yield from selling the bond at a discount will be $20 ÷ $980, or 2.04%.
In this way, yield and price are inversely related.
Calculating Yield to Maturity
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.
Yield to maturity represents the average return of the bond over its remaining term. A single discount rate is applied to all future interest payments to create a present value roughly equivalent to the price of the bond. The entire calculation takes into account the coupon rate, the current price of the bond, the difference between price and face value, and time until maturity.
- 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.