A:

The coupon rate is the rate of interest that the bond pays annually, while the yield to maturity is its average rate of return after accounting for the bond's purchase price.

Investing in bonds can generate profit in two ways. First, most bonds generate a fixed amount of income by paying interest annually or semi-annually. This interest rate is called the coupon rate and is expressed as a percentage of the bond's par value.

The par value of a bond is its face value. If a bond has a par value of $1,000 and a coupon rate of 7%, then it pays $70 in interest each year.

The par value of a bond is not its market price. In fact, the market price of bonds can swing substantially above or below par. If you purchase a bond below its par value, it is called discount. A bond with a market price above par is purchased at a premium.

Par value tells the investor how much money the issuing company must pay the bondholder once the bond matures. Regardless of the purchase price, the owner of a five-year, $1,000 bond will always receive $1,000 from the company that issued the bond after the five years have passed. Purchasing bonds at a discount can yield a profit for investors. A $1,000 bond purchased for $700 still pays $1,000 at maturity, generating a profit of $300.

Because coupon payments are not the only source of bond profits, the yield to maturity calculation incorporates the potential gains or losses generated by variations in market price. If an investor purchases a bond for its par price, the yield to maturity is equal to the coupon rate. If the investor purchases the bond at a discount, its yield to maturity is always higher than its coupon rate. Conversely, a bond purchased at a premium always has a yield to maturity that is lower than its coupon rate.

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