Bond Yield vs Coupon Rate: What’s the Difference?
Bond Yield vs. Coupon Rate: An Overview
A bond’s coupon rate is the interest rate it pays annually, while its yield is the rate of return it earns. The coupon rate of a bond is expressed as a percentage of its nominal value. Face value is simply the face value of the bond or the value of the bond as stated by the issuing entity.
Thus, a $1,000 bond with a coupon rate of 6% earns $60 in interest per year and a $2,000 bond with a coupon rate of 6% earns $120 in interest per year.
Key points to remember
- Coupon rates are the returns associated with regular interest payments made by bonds and are influenced by prevailing interest rates.
- The yield of a bond is the rate of return generated by the bond.
- The coupon rate of a bond is the interest rate that the bond pays annually.
- Also, the designated credit rating of a bond will influence its price and there may be times when looking at the price of a bond you find that it does not honestly show the relationship between other interest rates at all. and the coupon rate.
- For the coupon rate, the current yield and the yield to maturity to be the same, the price of the bond when purchased must be equal to its nominal value.
Coupon rates are largely influenced by interest rates set by the government. Therefore, if the government raises the minimum interest rate to 6%, all pre-existing bonds with coupon rates below 6% lose value.
Anyone looking to sell preexisting bonds must reduce their market price to compensate investors for the bonds’ lower coupon payments compared to newly issued bonds.
Buying a premium bond means buying it for more than face value. Buying a bond at a discount means paying less than its face value. Regardless of purchase price, coupon payments remain the same.
To understand the full extent of a rate of return on a bond, check its yield to maturity.
Rate of return
The performance of a bond can be measured in different ways. The current yield compares the coupon rate to the current market price of the bond. Therefore, if a $1,000 bond with a coupon rate of 6% sells for $1,000, the current yield is also 6%. However, since the market price of bonds can fluctuate, it may be possible to buy this bond at a price higher or lower than $1,000.
If that same bond is purchased for $800, the current yield becomes 7.5% because the annual coupon payments of $60 represent a larger portion of the purchase price.
A more comprehensive measure of a bond’s rate of return is its yield to maturity (YTM). Since it is possible to generate a profit or a loss by buying bonds above or below par, this return calculation takes into account the effect of the purchase price on the total rate of return. If the purchase price of a bond is equal to its face value, then the coupon rate, current yield and yield to maturity are the same.
When discussing bonds, it is important to note the many types of rates of return that exist. For the purposes of this article, we have focused primarily on current yield. But depending on the situation, it may be more appropriate to use yield to maturity, annual percentage yield (APY), yield to worst (YTW), yield to call, bond equivalent yield (BEY) or the actual annual yield. A good understanding of each and when to use them is helpful when evaluating bonds.
What does it mean if the coupon rate is higher than the yield?
If a bond’s coupon rate is higher than its yield, the bond will trade at a premium. This is because the fixed interest rate on the bond exceeds prevailing interest rates; therefore, people will pay a premium to earn these higher coupon payments. This is why bond prices fluctuate inversely to interest rates. When interest rates fall, bond prices rise.
What is the difference between coupon rate and interest rate?
The coupon rate is the interest rate paid by a bond relative to its face or nominal value. For a fixed-rate bond, it will be the same for its entire maturity. The prevailing interest rates may rise or fall in the meantime, which would instead affect the price of the bond (given its fixed coupon rate). In general, the coupon rate of a bond will be comparable to the interest rates prevailing when it was first issued.
How do you calculate the rate of return?
A bond’s yield, or coupon rate, is calculated by dividing its coupon payment by its face value. A discounted rate of return can be calculated by dividing its coupon by the current market price of the bond.