Key Difference – Yield to Maturity vs Coupon Rate
Yield to maturity and coupon rate are two critical aspects that should be understood when considering investing in bonds. A bond is a financial instrument issued by a company (corporate bonds) or the government (government bonds); in order to obtain access to capital from investors, which is similar to a loan. The key difference between yield to maturity and coupon rate is that yield to maturity is the rate of return estimated on a bond if it is held until the maturity date, whereas coupon rate is the amount of annual interest earned by the bondholder, which is expressed as a percentage of the nominal value of the bond.
CONTENTS
1. Overview and Key Difference
2. What is Yield to Maturity
3. What is Coupon Rate
4. Side by Side Comparison – Yield to Maturity vs Coupon Rate
5. Summary
What is Yield to Maturity
Yield to maturity is the total return receivable on a bond if the bond is held until the end of its maturity. Yield to maturity is considered to be a long-term bond yield although it is expressed as an annual rate. To be specific, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled. Yield to maturity is also known as ‘redemption yield’ or ‘book yield’.
How to Calculate Yield to Maturity
Yield to Maturity is calculated as below.
Yield to Maturity = Coupon + (Nominal Value – Price/Term to Maturity) / (Nominal Value+ Price/2) *100
Coupon Rate (refer below)
Nominal value = Original/Face Value of a bond
Term to Maturity = the end date of the life of the bond by which all the interest payments and face value should be paid
E.g. An investor purchases a bond for a price of $102.50 that has a nominal value of $100. The coupon rate is 5.25% with a term to maturity of 4.5 years. Yield to Maturity is calculated as,
Yield to Maturity = 5.25 + (100-102.50/4.5) / (100+102.50/2) = 4.63%
Yield to Maturity can be identified as an important yardstick for an investor to understand the amount of return a bond will generate at the end of the maturity period. If the investor has to select between several bonds, the yield to maturity of the bonds can be compared to decide on which one/ones to invest in. However, it should further be noted that yield to maturity should not be the only consideration for investing in bonds, certain non-financial factors should also be looked at by investors. For instance, the party issuing the bond may not pay the coupon and principal amount to the investor after some time. This is referred to as ‘default risk’. If the company has a good reputation and high credibility, risk of default will be significantly low.
Figure 1: Bond yields fluctuate over time
What is Coupon Rate
Coupon rate refers to the annual rate of interest earned by an investor for a bond held. As mentioned above, coupon rate is required to calculate the yield to maturity of a bond investment.
E.g. if a bond has a nominal value of $2,000 that pays interest biannually at $60, the coupon rate will be 3% (60/2,000 *100)
The coupon rate remains constant throughout the life of the bond. For this reason, bonds are also referred to as ‘fixed income securities’. The market price of the bond may fluctuate; however, the interest will be paid at the coupon rate.
What is the difference between Yield to Maturity and Coupon Rate?
Yield to Maturity vs Coupon Rate |
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| Yield to Maturity is the rate of return earned on a bond assuming it will be held until the maturity date. | Coupon rate is the annual interest rate earned by the bondholder. |
| Interdependency | |
| Yield to Maturity depends on the coupon rate, price and term of maturity of the bond. | The coupon rate is required to calculate the Yield to Maturity. |
Summary – Yield to Maturity vs Coupon Rate
Bonds are an attractive investment to equity and are invested in by many investors. While related, the difference between yield to maturity and coupon rate does not depend on each other completely; the current value of the bond, difference between price and face value and time until maturity also affects in varying degrees.
Reference:
1. Fontinelle, Amy. “Yield To Maturity (YTM).” Investopedia. N.p., 09 Aug. 2016. Web. 21 Feb. 2017.
2. “Yield / Risk.” SIX Swiss Exchange – Yield. N.p., n.d. Web. 21 Feb. 2017.
3. Ross, Sean. “What is the difference between yield to maturity and the coupon rate?” Investopedia. N.p., 15 Apr. 2016. Web. 21 Feb. 2017.
4. “The Relation of Interest Rate & Yield to Maturity.” Finance – Zacks. N.p., n.d. Web. 21 Feb. 2017.
Image Courtesy:
1. “Eurozone long-term government bond yields” By MartinD – Own work (CC BY-SA 3.0) via Commons Wikimedia