Bonds offer a fixed rate return on your investment. Bonds are a great investment option for those who are cautious about risk. They have a lower risk of default and provide a higher return than traditional options such as bank FDs.
However, investors often get confused when trying to invest in bonds. They tend to confuse the yield to maturity and coupon rate. Contrary to popular belief, these metrics are not the same thing. You might be curious about the differences between yield to maturity and coupon rate in relation to bonds. Continue reading to learn more.
Commonly, the coupon rate is the rate at which a bond pays interest to an investor. It is the annual interest rate that the bond pays relative to its face value. It is expressed as a percentage. Let's look at an example to understand how coupon rates work.
Let's say that a company issues bonds with a face-value of Rs. 10,000. This bond has a 10% annual interest rate. The coupon rate is 10% per year. If you invest Rs. 10,000 in the bond, you will receive Rs. You will get Rs. 10,000 if you invest Rs. 1000 per annum in interest payments
Before we look at the yield to maturity, it is important to understand that bonds can, once they have been subscribed to by investors, be traded in the open market just like equity shares.
Yield to maturity (YTM), is the rate at which an investor earns if he holds the bond until its maturity date. Only when an investor purchases a bond on the secondary market does the YTM become relevant.
The following formula can be used to calculate the yield to maturity for a bond:
|YTM = [Annual Interest Payment] + [Face Value – Current Trading Price / Remaining Year To Maturity] / [Face Value + Current price / 2]|
Let's look at an example to understand the concept yield to maturity.
Let's say that a bond has a face worth of Rs. With a coupon rate 10%, 10,000. The bond currently trades on the market at Rs. 9,200. Let's say that the bond matures in five years. The interest will be paid twice a year. As explained below, the yield to maturity for such a bond is calculated.
(1,000), + [(10,000- 9,200] / 5]/ [(10,000+ 9,200] / 2] = 0.12208 or 12.08%
The main difference between yield to maturity and coupon rate is that the coupon rates remain the same throughout the term of the bond. The yield to maturity changes depending on many factors, such as the remaining years until maturity and the current bond price.
Another example illustrates the distinction between yield to maturity and coupon rate. Let's say that a bond has a face worth of Rs. With a coupon rate 10%, 10,000. Let's examine how the coupon rate, and the yield to maturity, behave in different situations.
|The Bond Purchased at||Coupon Rate||Yield To Mature|
|A price that is lower than the face value (I.E. A Discount||10%||Higher than the Coupon Rate|
|A price that is higher than the face value (I.E. A premium||10%||It is lower than the coupon rate|
This example shows not only the difference in coupon rate and yield-to-maturity, but also the inverse relationship between yield-to maturity and bond price.
The YTM is the average return an investor will experience over the remaining life of the bond. This is another difference between the two metrics. However, the coupon rate is the annual interest payment an investor would receive.
The coupon rate should be considered for investors who buy a bond directly from the company via a new offer and intend to stay invested until maturity. In such cases, the yield to maturity is irrelevant. For bond traders who sell and buy bonds on the secondary market, the yield at maturity should be considered. Because the YTM calculation also includes any possible profits or losses resulting from changes in bond market prices,