Yield to Maturity vs. Coupon Rate: An Overview
A bond's yield to maturity (YTM) is the percentage rate of return for a bond, assuming that the investor holds the asset until its maturity date and receives all its remaining coupon payments and return of the principal (par value) at maturity. A bond's yield to maturity rises or falls depending on its market value and how many payments remain.
The coupon rate is the annual interest amount that the bond owner will receive. To complicate things, the coupon rate may also be referred to as the yield from the bond. Generally, a bond investor is likelier to base a decision on an instrument's coupon rate. A bond trader is more likely to consider its yield to maturity.
Key Takeaways
- 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 an investor can expect to receive while holding a particular bond.
- When it is purchased, a bond's yield to maturity and coupon rate are the same.
- As economic conditions change, investors may demand the bond more or less. As the price of the bond changes, the yield to maturity of the bond will inversely change.
- Though bonds may be issued with variable rates tied to SOFR (which replaced LIBOR), most bonds are issued with a fixed rate, often causing the coupon rate and yield to differ.
Yield to Maturity (YTM)
The yield to maturity (YTM) is an estimated rate of return. It assumes that the bond buyer will hold it until its maturity date and 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 the same.
However, changes in interest rates will cause the bond's market value to change as buyers and sellers find the yield offered more or less attractive under new interest rate conditions. This way, yield and bond price are inversely proportional and move in opposite directions. As a result, the bond's yield to maturity will fluctuate, while the coupon rate for a previously existing bond will remain the same.
Coupon Rate
The coupon rate or yield is the amount investors expect to receive in income as they hold the bond. Coupon rates are fixed when the government or company issues the bond, although bonds can be issued with variable rates. These variable rate securities are often pegged to SOFR or another publicly distributed yield.
The coupon rate is the yearly amount of interest that will be paid based on the face or par value of the security. Some bonds may be recorded to pay interest more than once per year. There are also specific dates for issuing dividends (i.e., holders on the date of record).
How to Calculate the Coupon Rate
Suppose you purchase an IBM Corp. bond with a $1,000 face value that is issued with semiannual payments of $10 each. Divide the total annual interest payments by the face value to calculate the bond's coupon rate. In this case, the total annual interest payment equals $10 x 2 = $20. The annual coupon rate for IBM bonds is thus $20 / $1,000 or 2%.
Software like Excel can come in handy when you're comparing bonds and want to calculate their total annual coupon payments or coupon rates.
Fixed-Rate and Market Value
While a bond's coupon rate and par/face value are fixed, the market 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 and $20 interest payments on the bond will remain unchanged.
When a bond sells for more than its face value, it sells at a premium. It sells at a discount when it sells for less than its face value.
Special Considerations
To an individual bond investor, the coupon payment is the source of profit.
To the bond trader, the potential for gains or losses is generated by variations in the bond's market price. The yield to maturity calculation incorporates the potential gains or losses caused 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 buys the bond at a discount, its yield to maturity will be higher than its coupon rate. A bond purchased at a premium will have ayield to maturitylower 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 are all considered.
What Is the Difference Between Coupon Rate and Yield?
The coupon rate is the stated periodic interest payment due to the bondholder at specified times. The bond's yield is the anticipated rate of return from the coupon payments alone, calculated by dividing the annual coupon payment by the bond's current market price. If the bond's price changes and is no longer offered at par value, the coupon rate and the yield will no longer be the same. This is because the coupon rate is fixed, and yield is a derivative calculation based on the bond price.
What Happens If the Yield to Maturity Is Greater Than the Coupon Rate?
A bond's yield will often stray from the original yield at the time of issue. When a bond's yield differs from the coupon rate, the bond is either trading at a premium or a discount to incorporate changes in market conditions. Though the coupon rate remains fixed, the bond's yield will fluctuate due to changing prices.
What Is the Relationship Between Bond Price and Yield?
A bond's price moves inversely to its yield to maturity rate. As interest rates rise, investors will demand greater returns. Therefore, the price of bonds will fall, naturally resulting in a rise in the yield to maturity rate. Alternatively, as interest rates fall, the bonds become more attractive due to their fixed rates, their prices increase due to demand, and their yield falls.
The Bottom Line
A bond's yield to maturity is the total amount received by the bond owner when it matures, expressed as a percentage. This includes the combination of interest payments and the return of principal. A bond's coupon rate is the interest rate paid throughout the bond's life.
