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What is the difference between a bond’s coupon rate and yield to maturity?

Quick Take on Fixed Income
April 2015

Q: What is the difference between a bond’s coupon rate and yield to maturity?

A: The coupon rate tells you the annual amount of interest paid by a fixed income security. For example, a Treasury bond with a coupon rate of 5 percent will pay you $50 per year per $1,000 of face value of the bond. The coupon rate, however, tells you very little about the yield. For most securities, the yield is a good proxy for the return of the fixed income security (that is, how much you can expect your wealth to increase if you purchase the security) and is far more meaningful than the coupon rate. To illustrate, consider these two Treasury bonds:

  • 8.875 percent coupon, February 2019 maturity
  • 2.75 percent coupon, February 2019 maturity

Both bonds mature around the same time, but they have enormous differences in coupon. One is paying coupon interest of $88.75 per year per $1,000 of face value and the other is paying $27.50, yet one trades at a yield to maturity of 2.40 percent and the other at 2.41 percent. This means they are priced in a way to provide essentially the same return. You have to pay significantly more to buy the bond with the relatively high coupon than the bond with the lower coupon. The net result is that either purchase has essentially the same yield to maturity, or expected return.

Another measure of yield that sometimes can be referenced is current yield, which is calculated by dividing a bond’s annual cash flow by its current price. This measure is not an accurate reflection of the actual return that you will receive because it only takes into account the coupon and current price as opposed to yield to maturity, which takes into account those two factors as well as the par value and time to maturity, providing a more complete picture. There are some brokers who will quote current yield as opposed to yield to maturity because the current yield is typically higher.

For example, let’s say a Texas water bond with a coupon of 6.25 percent and a maturity date of June 2021 is currently trading at 126.686. At that price, the current yield is 4.93 percent while the actual yield to maturity is only 1.63 percent.

Summary

When considering fixed income options, it is important to understand the differences among coupon rate, yield and expected return. While each piece does tell an important story, the best indicator of return on the security is yield to maturity.


Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

 

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