Investors find it daunting to understand the return on their chosen investment product. All of us aim for high returns and it is important to choose the right type of investment product for the same. You should start by understanding the difference between a coupon rate and the yield to maturity. Once you get this difference, you will be able to make investment decisions easily. A coupon rate is what the bond paid when you purchased it. The yield to maturity is the amount you will earn in the future.
Let us take an example here. The U.S. Treasury could issue a 20-year bond during 2020 which is due in 2040 at a coupon rate of 2%. It means that the investor who purchases the bond and holds it until 2040 will receive 2% each year or, in simple terms, $20 for $1000 they invest. he coupon will remain 2% and it does not change. Now it is important to remember that there are various bonds that trade in market once they have been issued. T
It leads to fluctuation in the actual price of the bond over the period of the trading day over the tenure of 20 years. The coupon is the fixed interest amount the bond will earn every year. It is usually a set amount which is a certain percentage of the bond price.
Yield to Maturity
The yield to maturity is the amount you will earn if you hold the bond until maturity. If by the end of 2030, the interest rates go up and the new bonds are issued with a yield of 4%. The investor will choose a bond at 4%. Hence, if you now want to sell the bond with 2% coupon, the price of the bond will fall and only then you will attract buyers. The price of a bond and its yield move in an opposite direction. When the yield rises from 2% to 4%, the price of the bond will fall. However, if the price falls, say from $1000 to $500, the initial $20 payout is now a yield of 4%.
In this case, the yield to maturity of the bond could be higher than 4%. It will depend on the number of years remaining in the total lifespan of the bond and the discount an investor received at the time of purchase of the bond. If an investor buys a bond at $500, then at the time of maturity, the price will get back to $1,000. This will lead to an increase in the yield to maturity.
Coupon rate vs. Yield to Maturity
The yield to maturity is equal to the coupon rate when an investor buys the bond at its original price. Hence, if you want to buy a new bond and if you plan to hold it until maturity, it is important to consider the coupon rate. When you buy a bond at a discount, your yield to maturity will be more than the coupon rate. If you purchase the bond at a premium, you will have a yield to maturity that is lower than the coupon rate.
When you look at an individual bond, you need to consider the yield to maturity over and above the coupon rate. The yield to maturity will show the amount that you will receive if you invest in the particular bond.
The coupon rate is the interest rate that is annually paid and the yield is the rate of return it generates. The coupon rate will be based on the face value of the bond. It is usually influenced by interest rates set by the Government. Credit rating of the bond will also have an impact on the price. It can also happen that when you look at the bond price, you notice that it shows no relationship with other interest rates or coupon rate at all.
What should you consider?
To purchase at a premium means you are paying more than the par value of the bond and when you purchase at a discount, you are paying less than the par value. Irrespective of the price, coupon payment will remain the same. If you want to know the rate of return of a bond, you need to consider the yield to maturity. You can generate high profit by buying bonds below par and holding them until maturity. If the purchase price of a bond is equal to the par value, then the current yield, coupon rate and yield to maturity will be the same.
When investing in bonds, it is best to understand the coupon rate and yield to maturity. It is the yield to maturity that will make all the difference to the amount you earn at the end of the holding period of the bond.