Bond Yield Rate vs. Coupon Rate: An Overview
A bond's coupon rate is the rate of interest it pays annually, while its yield is the rate of return it generates. A bond's coupon rate is expressed as a percentage of its par value. The par value is simply the face value of the bond or the value of the bond as stated by the issuing entity. Thus, a $1,000 bond with a coupon rate of 6% pays $60 in interest annually and a $2,000 bond with a coupon rate of 6% pays $120 in interest annually.
- Coupon rates are influenced by government-set interest rates.
- A bond’s yield is the rate of return the bond generates.
- A bond’s coupon rate is the rate of interest that the bond pays annually.
- In addition, a bond's designated credit rating will influence its price and it can happen that when looking at a bond's price, you will find it does not honestly show the relationship between other interest rates and the coupon rate at all.
- In order for the coupon rate, current yield, and yield to maturity to be the same, the bond’s price upon purchase must be equal to its par value.
Coupon rates are largely influenced by the interest rates set by the government. Therefore, if the government increases the minimum interest rate to 6%, then any pre-existing bonds with coupon rates below 6% lose value.
Anyone looking to sell pre-existing bonds must reduce their market price to compensate investors for the bonds' lower coupon payments relative to the newly issued bonds.
To buy a bond at a premium means to purchase it for more than its par value. To purchase a bond at a discount means paying less than its par value. Regardless of the purchase price, coupon payments remain the same.
To understand the full measure of a rate of return on a bond, check its yield to maturity.
A bond's yield can be measured in a few different ways. Current yield compares the coupon rate to the current market price of the bond. Therefore, if a $1,000 bond with a 6% coupon rate sells for $1,000, then the current yield is also 6%. However, because the market price of bonds can fluctuate, it may be possible to purchase this bond for a price that is above or below $1,000.
If this same bond is purchased for $800, then the current yield becomes 7.5% because the $60 annual coupon payments represent a larger share of the purchase price.
A more comprehensive measure of a bond's rate of return is its yield to maturity. Since it is possible to generate profit or loss by purchasing bonds below or above par, this yield calculation takes into account the effect of the purchase price on the total rate of return. If a bond's purchase price is equal to its par value, then the coupon rate, current yield, and yield to maturity are the same.