Yield to Maturity vs. Coupon Rate: An Overview
When investors consider buying bonds they need to look at two vital pieces of information: the yield to maturity (YTM) and the coupon rate.
Investment-quality bonds are low-risk investments that generally offer a rate of return slightly higher than a standard savings account. They are fixed-income investments that many investors use for a steady stream of income in retirement. Investors of any age may add some bonds to a portfolio to lower its overall risk profile.
- The yield to maturity (YTM) is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond's yield to maturity rises or falls depending on its market value and how many payments remain to be made.
- The coupon rate is the annual amount of interest that the owner of the bond will receive. To complicate things the coupon rate may also be referred to as the yield from the bond.
Generally, a bond investor is more likely to base a decision on an instrument's coupon rate. A bond trader is more likely to consider its yield to maturity.
Comparing Yield To Maturity And The Coupon Rate
- The yield to maturity is the estimated annual rate of return for a bond assuming that the investor holds the asset until its maturity date and reinvests the payments at the same rate.
- The coupon rate is the annual income in investor can expect to receive whle holding a particular bond.
- At the time it is purchased, a bond's yield to maturity and its coupon rate are the same.
Yield to Maturity (YTM)
The YTM is an estimated rate of return. It assumes that the buyer of the bond will hold it until its maturity date, and will reinvest each interest payment at the same interest rate. Thus, yield to maturity includes the coupon rate within its calculation.
YTM is also known as the redemption yield.
YTM and Market Value
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, when the bond is first issued, the coupon rate and the yield are usually exactly the same.
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 or par value of the bond to change as its issuer 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 is the amount that investors can expect to receive in income as they hold the bond. Coupon rates are fixed when the government or company issues the bond.
The coupon rate is the yearly amount of interest that will be paid based on the face or par value of the security.
How to Calculate Coupon Rate
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%.
Fixed Rate and Changing Value
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.
When a bond sells for more than its face value, it sells at a premium. When it sells for less than its face value, it sells at a discount.
To an individual bond investor, the coupon payment is the source of profit.
To the bond trader, there is the potential gain or loss generated by variations in the bond's 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 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, the bond's coupon rate, current price, and the difference between price and face value all are considered.