Understanding coupon rate and bond yield is crucial for any investor considering fixed-income securities. These two terms, while related, represent different aspects of a bond's return and value. Let's dive into the details.
What is the Coupon Rate?
The coupon rate is the rate at which investors expect to receive interest payments, paid by the bond issuer. The coupon rates are fixed by the government or the company that issues the bonds and depends upon the bond’s face value (the amount of money bondholders will receive when the bond matures). Let’s try to understand with an example: A company issues a bond with a face value of $1000 and a coupon rate is 5%, which means the bondholder will receive an interest payment of $50.
What is Bond Yield?
A bond's yield to maturity (YTM) is the annualized rate of return assuming the investor holds the bond until it matures, receiving all remaining coupon payments and the return of the principal at maturity. The YTM fluctuates based on the bond's current market value and the number of remaining coupon payments.
How Do You Calculate Yield Rate?
A bond's yield, or coupon rate, is calculated by dividing its annual coupon payment by its face value. The current yield can be determined by dividing the annual coupon payment by the bond's current market price
A bond's yield can be evaluated in several ways. The current yield is determined by comparing the bond's coupon payment to its current market price. For instance, if a bond with a face value of $1,500 has a 4% coupon rate and is sold for $1,500, the current yield is 4%. However, since bond market prices fluctuate, the bond might sell for more or less than $1,500.
If this bond is instead purchased for $1,200, the current yield increases to 5%, as the $60 annual coupon payment constitutes a larger portion of the reduced purchase price.
Coupon Rate Vs Bond Yield
- The coupon rate is the fixed periodic interest payment made to bondholders at specified intervals.
- The bond's yield, however, is the expected rate of return from these coupon payments, calculated by dividing the annual coupon payment by the bond's current market price.
If the bond's market price deviates from its par value, the coupon rate and the yield will differ because the coupon rate remains fixed, while the yield adjusts based on the bond's current price.
What Is the Relationship Between Bond Price and Yield?
A bond's price moves inversely to its yield to maturity (YTM). When interest rates rise, investors seek higher returns, causing bond prices to drop and YTM to increase. Conversely, when interest rates fall, bonds with fixed rates become more appealing, driving up their prices due to increased demand and subsequently lowering their YTM.
Bottom line
The coupon rate is crucial for bond investors who purchase bonds in the primary market and plan to hold them until maturity, as they are primarily concerned with the fixed periodic interest payments. However, in the secondary market, the bond yield is of greater importance to investors. This is because the yield reflects the potential profit or loss resulting from changes in the bond's market price, thereby providing a more comprehensive measure of the bond's return.
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