Bonds are securities that offer you a fixed rate of return on your investment. They’re one of the best investment options for risk-averse investors since they possess a much lower risk of default and offer a higher return compared to traditional options like bank FDs.
That said, most investors, when looking to invest in a bond, seem to get confused between two metrics – the coupon rate and the yield to maturity. Contrary to popular opinion, both of these metrics don’t represent the same thing. If you’re wondering what the difference between coupon rate and yield to maturity is with respect to a bond, then read on to find out more.
What is the coupon rate?
The rate at which a bond makes interest payments to the investor is commonly termed as the coupon rate. It represents the annual interest rate paid out by the bond with respect to its face value, and it is denoted as a percentage. Let’s take up an example to better understand the concept of coupon rates.
Assume that a company issues a bond with a face value of Rs. 10,000. The rate of interest on this bond is set at 10% per annum. Here, the 10% per annum is what is known as the coupon rate. So, when you invest Rs. 10,000 in the bond, you will receive Rs. 1,000 per annum as interest payments.
What is yield to maturity?
Before we take a look at what yield to maturity is, it is important for you to know that bonds, once they’re initially subscribed by investors, can be traded openly in the market like equity shares.
The yield to maturity (YTM) is the rate of return that an investor earns when he holds the bond till the maturity date. The YTM becomes relevant only when an investor buys a bond from the secondary market.
To calculate the yield to maturity of a bond, the following formula is used.
| YTM = {(annual interest payment) + [(face value – current trading price) ÷ remaining years to maturity]} ÷ [(face value + current price) ÷ 2] |
Let’s take up an example to better understand the concept of yield to maturity.
Assume that there’s a bond with a face value of Rs. 10,000 with a coupon rate of 10%. Say the bond is currently trading on the market for Rs. 9,200. And say there are 5 years remaining till the maturity of the bond, with the interest being paid out two times in a year. The yield to maturity of such a bond would then be calculated as explained below.
{(1,000) + [(10,000 – 9,200) ÷ 5]} ÷ [(10,000 + 9,200) ÷ 2] = 0.1208 or 12.08%
What is the difference between coupon rate and yield to maturity?
The primary difference between coupon rate and yield to maturity is that the coupon rate stays the same throughout the tenure of the bond. However, the yield to maturity undergoes a change depending on various factors such as the years remaining till maturity and the current price at which the bond is being traded.
Here’s another example that clearly illustrates the difference between coupon rate and yield to maturity. Assume that there’s a bond with a face value of Rs. 10,000 with a coupon rate of 10%. Let’s take a look at how the coupon rate and the yield to maturity behave under different circumstances.
| When the bond is purchased at | Coupon Rate | Yield to maturity |
| Face value | 10% | 10% |
| A price that’s lower than the face value (i.e. at a discount) | 10% | Higher than the coupon rate |
| A price that’s higher than the face value (i.e. at a premium) | 10% | Lower than the coupon rate |
The above example not only clearly indicates the difference between coupon rate and yield to maturity, but also shows the inverse relationship between yield to maturity and the price of the bond.
Another difference between these two metrics is that the YTM represents the average rate of return that an investor is likely to experience over the bond’s remaining lifetime. The coupon rate, however, represents the annual interest payment that an investor would receive.
Conclusion
For investors who purchase a bond directly from the company through a new offer with the intention of staying invested till the date of maturity, the coupon rate is what they should consider. The yield to maturity is completely irrelevant in such a scenario. That said, for bond traders, who buy and sell bonds in the secondary market, the yield to maturity is what they should consider. This is because the YTM calculation also involves any potential profits or losses as a result of the changes in the market price of the bond.
