A bond's coupon rate is equal to its yield to maturity (YTM) when its purchase price is the same as its par value.
The par value of a bond is its face value, or the stated value of the bond when it is issued. It is also the value of the bond at maturity. That par value is determined by the entity (such as a company or a government) that issues the bond. Most bonds have par values of $1,000.
Bonds have various features in addition to par value, including the coupon rate, yield to maturity, current yield, and maturity date. Their prices react to changing interest rates and the availability of more lucrative bonds.
Read on to learn more about these important aspects of bonds.
Key Takeaways
- The coupon rate and yield to maturity for a bond will be the same if the bond's purchase price is identical to its par value.
- Par value is a bond's face value.
- YTM estimates the total amount that an investor can earn through maturity, under certain conditions.
- A bond bought at a discount from par will have a YTM that's higher than the coupon rate.
- A bond bought at a premium to par will have a YTM that's lower than the coupon rate.
What Is the Coupon Rate?
The coupon rate of a bond is its interest rate, or the amount of money it pays the bondholder each year, expressed as a percentage of its par value. A bond with a $1,000 par value and coupon rate of 5% pays $50 in interest annually until it matures.
Suppose you purchase an IBM Corp. bond with a $1,000 face value. It is issued with semi-annual payments of $10, or a coupon of $20. To calculate the bond's coupon rate, divide the coupon by the par or face value.
$20 ÷ $1000 = 2%.
In addition, coupons are fixed. No matter what price a bond trades for, the interest payments always remain the same. So, with our IBM bond, if interest rates went up, driving down the price of IBM's bond to $980, the $20 coupon would remain unchanged.
What Is Yield to Maturity?
Yield to maturity is an estimate of all that a bondholder may earn over the life of a bond. This includes cash from coupon payments (referred to as the coupon), compounded interest, and any profit earned or loss accrued due to the difference between what the bondholder paid for the bond and the par value at maturity.
The reason yield to maturity is an estimate rather than an accurate measure of return is because it's based on three assumptions that often aren't (or cannot be) met:
- You hold the bond to maturity so that it's redeemed at par.
- You reinvest all coupon payments.
- You reinvest all coupon payments at the same rate as the YTM quoted.
Any deviation from these assumptions will affect the YTM. For example, if you have to sell a bond prior to its maturity date, the selling price wouldn't be par. It would be higher or lower and thus, affect the return estimated by the YTM.
That is, if you redeemed at a discount (prior to maturity), you'd experience a loss that's not accounted for by the YTM. If you spend coupon payments instead of reinvesting them, that also affects the YTM because it includes them. And even if you reinvest these payments, you may do so at a different rate than the YTM. So again, your return would no longer match the quoted YTM.
Because yield to maturity is an estimate only, it may be best used to compare different bonds that have varying coupons, prices, and years to maturity. This can help you evaluate your investment opportunities.
Current Yield
Current yield is not the same as YTM. It's derived only from the coupon and the price of the bond.
To get the current yield, divide the coupon by the bond's price in the secondary market. For example, a bond with a coupon of $20 and a price of $1,100 has a current yield of 1.82% ($20 ÷ $1,100). A bond with a coupon of $20 and a price of $980 has a current yield of 2.04% ($20 ÷ $980).
Maturity Date
A bond's maturity date is simply the date on which the bondholder receives repayment for their investment. At maturity, the issuing entity must pay the bondholder the par value of the bond, regardless of its current market value.
This means that if an investor purchased a five-year $1,000 bond for $800, they'd collect $1,000 at the end of five years in addition to any coupon payments they received during that time.
Bond Prices
Bond prices move in the opposite direction of interest rates. As interest rates go up, the prices of pre-existing bonds go down. As rates decline, the prices of bonds go up.
To demonstrate why this is so, let's say that you bought a $1,000 bond with a term of 10 years and a 4% interest rate. Sometime thereafter, the government raises interest rates. New bonds with the same term will then have higher coupon rates compared to the 4% bond that you bought. What happens if you decide to sell?
To entice investors to purchase your 4% bond when they could buy one with a more attractive 7% rate, you'll have to drop its price (to a level that actually yields 7%).
If interest rates were to drop to 3%, your pre-existing 4% bond would rise in price because it's now more attractive than newly issued, lower rate bonds with the same term.
If you invest in bonds and your outlook is for interest rates to drop, it's possible to make a profit, in addition to the return generated by coupon payments, by purchasing bonds at a discount and selling if and when rates decrease, causing prices to rise.
Once a bond starts trading, it will trade above or below par.
Comparing Bond Coupon Rates and YTMs
As mentioned, the yield to maturity calculation incorporates the potential gains or losses generated by the difference between the purchase price and the par value (again, the redemption amount at maturity).
If an investor purchases a bond for its par value, the yield to maturity quoted will be equal to the coupon rate. If the investor purchases the bond at a discount to par, the yield to maturity will be higher than the coupon rate. And if a bond is purchased at a premium to par, the yield to maturitywill be lower than the coupon rate.
Why Do Bond Prices Go Up When Interest Rates Go Down?
Prices for bonds in the market rise when interest rates go down because newly issued bonds with the same terms will have those lower interest rates as coupon rates. This makes existing bonds, with higher coupon rates, more attractive to investors. Demand for them will increase, forcing prices to climb.
What Is Interest Rate Risk?
It's the unavoidable risk that every bond's price will change in response to a change in interest rates. It is considered the biggest risk for bonds, followed by the risk posed by a change in the credit quality of a bond's issuer.
What Can Yield to Maturity Tell Me?
It can provide you with an estimate of the total return that a bond may offer through maturity, based on its total cash flows. It's an estimated, rather than an actual, yield because it depends on factors that may not occur: the bond is held to maturity, all coupons are reinvested, and all reinvestments are made at the YTM rate.
The Bottom Line
A bond's coupon rate is equal to its yield to maturity only when the price paid for the bond is the same as its par value.
Therefore, if the price of a bond is less than par, the YTM will be higher than the coupon rate. If it's higher than par, the YTM will be lower than the coupon rate.
Bonds have important features and risks that investors should understand before they invest in them. Be sure to do the appropriate research and/or to consult your financial advisor for more information.
