Difference Between Coupon Rate and Bond Yield: A Simple Guide
Bonds are a type of debt instrument that allows businesses to raise funds for expansion or operational needs without diluting their capital. Like term loans, bonds come with a set maturity period, during which the business is required to repay the borrowed amount along with the interest.
Typically, governments and businesses issue them to raise funds. Since it is a debt instrument, the investors earn interest.
Investors must understand the difference between bond coupon and yield to make prudent decisions before investing. The differences help investors understand the actual return they can generate from their bond investment.
Before getting into the core difference between coupon and yield, it is necessary to understand them individually.
What Is A Coupon Rate?
The interest rate that bond issuers pay on the par value of the bond is known as the coupon rate. This rate is paid regularly and is calculated based on the bond's par value, not its market price.
When determining the coupon rate, a bond issuer considers several factors, including the interest rates that are currently on the market.
A bond's value rises or falls in tandem with changes in market interest rates, which might be lower or greater than the coupon rate. Bonds with greater coupon rates offer protection against increasing market interest rates since the coupon rate is fixed for the duration of the bond.
Coupon Rate Formula For Bonds
Understanding the coupon rate formula helps individuals anticipate the possible future earnings and credit risk profiling. It enables individuals to compare the rates of different bonds available in the market and make prudent fiscal decisions.
The bond coupon rate formula states the following.
Coupon rate formula= (Total of yearly coupon payments / Face value) x 100
Bonds with greater coupon rates are preferred by investors over those that have decreased coupon rates.
Example Of Coupon Rate
Through illustrations and actual bonds listed on the market, investors can best understand the meaning of bond coupon rates. The combination of illustration with the real world will enable investors and market enthusiasts to connect the theoretical concept with real-world applications.
Illustration
Suppose Amisha purchased a bond of face value INR 1,000. The bond is presently trading at INR 1,500. The coupon rate is 10% per annum. Amisha will get a return of INR 100 till the bond matures.
Bonds available in the market
Bond issuer | Face value | Coupon rate |
National Highway Authority of India | 1,000 | 7.60 |
Indian Railway Finance Corporation | 1,000 | 7.64 |
NTPC limited | 10 | 8.49 |
What Is Bond Yield?
In essence, yield means return. Yields have the same meaning in the context of bonds. Simply put, investors need to be aware of the many yield kinds that are available for bonds. The anticipated return on a bond over time is known as the bond yield. It is stated as an interest rate or percentage.
The most common kind of yield that comes to mind when we talk about bond yield is the bond coupon rate. However, there are other types of bond yields as well.
Types Of Bond Yields
There are different categories of bond yields. This section will explain each category independently and with examples.
1. Current Yield On Bonds
Since bonds are traded on the secondary market, their market price may be higher or lower than their face value. Current yield, also known as current bond yield rates, uses the bond's market price as the denominator rather than its face value.
Example: For example, the INR 10,000 bond yields a INR 900 payment each year. There are now two possible scenarios.
Case A= Bond’s market price is below FV, say INR 9,800
Case B= Bonds’s market price is above the FV, say INR 10,300
Now, Current yield on bonds= (Yield / Market price)x100
In the first scenario, the bond's current yield= (900/9,800)x100 = 9.18%.
The bond's current yield in the second case= (900/10,300)x100 = 8.74%.
2. Yield To Maturity
If a bond stays invested till it matures, its yield to maturity (YTM) indicates its yearly rate of return. Whether investors bought it on the primary market or the secondary market, it covers multiple parameters. Some of them are listed below.
- The effect of all coupon payouts as well as the principal return upon maturity.
- It also takes into account whether investors paid a premium or a discount for the bond when they purchased and redeemed it.
This is potentially the most significant yield data for bond traders.
The formula for yield to maturity is:
Here,
- C is the annual coupon payment,
- F is the face value of the bond,
- P is the current price of the bond,
- n is the number of years to maturity
Say, an INR 1000 bond with a maturity of 10 years is trading for INR 1, 500. The coupon rate is 10% per annum.
Annual interest payment= (10/100) * 1000= INR 100
(Face Value ? Prevailing Trading Price)/ Period left till maturity= (1000-1500)/10 = -50
((Face Value + Current Market Price)/2)?= (1000+1500)/2= 1,250
Yield to Maturity= (100-50)/ 1250= 0.04
Yield to Maturity (%)= 4%
Key Differences: Coupon Rate vs. Yield-to-maturity
Although coupon rate is a type of bond yield, there are multiple differences between coupon rate and yield to maturity. Consequently, in this part, we shall explore a detailed study of these differences.
Parameter | Coupon rate | Yield-to-Maturity |
Meaning | The interest rate that bond issuers pay on the par value is known as the bond coupon rate. | If a bond stays invested till it matures, its yield to maturity (YTM) indicates its yearly rate of return. |
Calculation Method | The formula for coupon rate= (Total of yearly coupon payments / Face value) x 100 | The formula for yield to maturity = Annual Interest Payment + (Face Value ? Prevailing Trading Price/Period left till maturity)/(Face Value + Current Market Price/2)? |
Influence of Market Price | It is not affected by market volatility. | It changes with market price because the formula for calculation includes factors like prevailing trading price. |
Impact on Investor Returns | Since the rate is established at issuance and stays constant, it provides predictable income that is unaffected by market changes. | The relationship between bond yields and prices is asymmetrical. YTM increases when prices fall and decreases when prices rise. |
Conclusion
The Indian financial assets landscape offers a wide range of securities. Bonds stand out as a unique asset class that balances security with return. Understanding the difference between bond yield and coupon rate can help investors make more informed decisions. While the coupon rate shows the return investors can expect, the yield-to-maturity gives a clearer picture of the true value of the return generated. Comparing various securities enables investors to find the ideal balance between risk and return.
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Frequently Asked Questions On Coupon Rate and Bond Yield
1. What is a 10% coupon bond?
A bond that pays a set yearly interest rate equal to 10% of its face value is known as a 10% coupon bond. This implies that, notwithstanding changes in the market, the bondholder will get 10% of the bond's face value in interest annually.
2. Who pays the coupon rate?
Coupon rate payments are made by the bond issuer. The interest rate paid on the bond's face value by the bond issuer is known as the coupon rate. A fixed-income security's nominal yield is known as its coupon rate. The rate is decided by the issuer.
3. What is the highest bond rating?
AAA is the highest bond rating. It denotes the greatest quality and lowest default risk of any bond. Bonds are rated by credit rating agencies that give investors a comprehensive idea of the creditworthiness of a company.
4. Which is called a zero-coupon bond?
A zero-coupon bond, often referred to as an accrual bond or a discount bond, is a type of debt instrument. The bond is offered at a discount to its face value rather than paying interest to the bondholder. At maturity, the bondholder is paid the whole face amount of the bond.
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