How are bond yields different from coupon rate?

By: | Published: December 23, 2017 10:09 AM

Bond's coupon rate is the actual amount of interest income earned on the bond each year based on its face value.

Bonds, Indian bonds, DBS bank, Reserve Bank of India, Markets, Narendra Modi, BJP, Bloomberg surveyA bond’s yield to maturity (YTM) is the estimated rate of return based on the assumption it is held until maturity date and not called. (Image: Reuters)

It’s not uncommon to find people confused between yields and coupon rates of a bond. Even the best in the trade sometimes miss out on the technical difference at times. Here we will ensure our readers get to know the basic difference between the two with help of proper examples. According to Investopedia, a bond’s coupon rate is the actual amount of interest income earned on the bond each year based on its face value. A bond’s yield to maturity (YTM) is the estimated rate of return based on the assumption it is held until maturity date and not called. Yield to maturity includes the coupon rate within its calculation and in general, investors are more likely to make investment decisions based on an instrument’s yield to maturity than its coupon rate.

For example a bond is issued with a face value of Rs 2,000, and it is issued with semi-annual payments of Rs 20. To calculate the bond’s coupon rate, divide the total annual interest payments by the face value. In this case the total annual interest payment equals Rs 20 x 2 = Rs 40. The annual coupon rate for bond is, therefore, equal to Rs 40 ÷ Rs 2000 = 2%. The coupons are fixed; no matter what price the bond trades for, the interest payments always equal Rs 40 per year. The coupon rate is often different from the yield. A bond’s yield is more accurately thought of as the effective rate of return based on the actual market value of the bond. At face value, the coupon rate and yield equal each other. If you sell your  bond at a Rs 100 premium, the bond’s yield is now equal to Rs 40 / Rs 2,100 = 1.90%. Assuming interest rates increased and the price of your bond fell to Rs 1980, your yield from selling the bond at a discount will be Rs 40 / Rs 1980 = 2.02%.

Bond yield and price share an inverse relationship

Imagine Mr.X purchases a bond for Rs 1,000.The bond matures in four years. The coupon rate of the bond is 5%. Therefore, it pays Rs 50 a year in interest. After one year, interest rates rise to 6% and Mr. X decides to sell his bond as he urgently requires his initially invested Rs1000. Once he places an order to sell his bond, his order would enter the market and interested buyers would compare this particular bond with the other bonds in the market at that particular point in time. Since the interest rates must have gone up in the market after one year, a newly issued Rs 1000 bond with a maturity period of 4 years (the time left for the bond from Mr.X to get matured) would be introduced in the market by then that would be paying the interest of 6%. This accounts for Rs 60 a year. Interestingly, if an investor purchases bond from Mr.X for Rs 1000 he would receive Rs 50 * 4 or Rs 200 in interest over the remaining four years. And, if the same investor purchases a new bond for Rs 1000 he would receive Rs 60 * 4 or Rs 240 in interest over the remaining four years. In short, there is no enticement for the investor to buy a bond of Mr.X at the face value of Rs 1000 when he could make more profit after purchasing the new bond with an increased interest rate at same par value. Therefore, in such circumstances, Mr.X has to sell his bond at a discount to make it look more attractive. He should sell it at around Rs 960 to make it look more attractive. The investor would now receive Rs 200 interest in addition to Rs 40 of principal when the bond matures. As investor has to pay less for the bond he would receive same profit over same maturity period similar to a newly issued bond paying a much higher interest rate. Therefore, bond prices have to go down to adjust for any rise in interest rates in the market.

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