Are Yield to Maturity and Coupon Rate the Same Thing?
What is Coupon Rate and Yield to Maturity ?
A bond’s coupon rate is the amount of interest income earned on the bond each year based on its face value. Yield to Maturity is the estimated rate of return assuming that it is held until its maturity date. Thus, yield to maturity includes the coupon rate within its calculation.
Generally, a bond investor is more likely to make a decision based on an instrument’s yield to maturity than on its coupon rate.
Calculating Coupon Rate
Suppose you purchase an Apple bond with a $1,000 face value that is issued with semi-annual payments of $10 each. To calculate the bond’s coupon rate, divide the total annual interest payments by the face value. In this case, the total annual interest payment equals $10 x 2 = $20. The annual coupon rate for IBM bond is, therefore, $20 ÷ $1,000, or 2%.
That coupon rate is fixed. 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 Apple’s bond down to $900, the 2% coupon on the bond will remain unchanged.
Calculating Yield to Maturity
At face value, the coupon rate and the yield are the same numbers. But say that interest rates fall and the Apple bond is sold at a $100 premium. The bond’s yield is now equal to $20 ÷ $1,100, or 1.82%.
If interest rates increased, the price of that bond might fall to $900. The yield from selling the bond at a discount will be $20 ÷ $980, or 2.04%. In this way, yield and price are inversely related.
How Coupon Rate Affects the Price of a Bond
When the prevailing market interest rate is higher than the coupon rate of the bond, the price of the bond is likely to fall because investors would be reluctant to purchase the bond at face value now, while they could get a better rate of return elsewhere. Conversely, if prevailing interest rates fall below the coupon rate the bond is paying, then the bond increases in value (and price) because it is paying a higher return on investment than an investor could make by purchasing the same type of bond now, when the coupon rate would be lower, reflecting the overall decline in interest rates.
Coupon Rate vs. Yield to Maturity
Most investors consider the yield to maturity a more important figure than the coupon rate when making investment decisions. The coupon rate remains fixed over the lifetime of the bond, while the yield to maturity is bound to change. When calculating the yield to maturity, you take into account the coupon rate and any increase or decrease in the price of the bond.
If an investor purchases a bond at par value, or face value, the yield to maturity is equal to its coupon rate. If the investor purchases the bond at a discount, its yield to maturity will be higher than its coupon rate. A bond purchased at a premium will have a yield to maturity that is lower than its coupon rate.
For example, if the face value of a bond is $1,000 and its coupon rate is 2%, the interest income equals $20. Whether the economy improves, worsens or remains stagnant, the interest income does not change. Assuming that the price of the bond increases to $1,500, the yield to maturity changes from 2% to 1.33%, i.e., $20/$1,500= 1.33%. If the price of the bond falls to $800, the yield to maturity will change from 2% to 2.5%, i.e., $20/$800= 2.5%. The yield to maturity only equals the coupon rate when the bond sells at face value. The bond sells at a discount if its market price is below the par value, and in such a situation, the yield to maturity is higher than the coupon rate. A premium bond sells at a higher price than the face value, and its yield is lower than the coupon rate.
Summary
- At the time it is purchased, a bond’s yield to maturity and coupon rate are the same.
- The bond’s yield to maturity rises or falls depending on its market value and how many payments remain to be made.
- Coupon rate is fixed. No matter what price the bond trades for, the coupon rates will always remain the same.
Source :
https://www.investopedia.com/what-difference-between-yield-maturity-and-coupon-rate.asp
https://corporatefinanceinstitute.com/resources/knowledge/finance/coupon-rate/
Gitman, Lawrence J. 2015. Principles of Managerial Finance 15th Edition. New York: Pearson
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