Coupon Rate and Yield to Maturity (YTM)
If a bond says '5% a year,' do you really earn 5%? In fact, depending on the price you paid, your actual return may not be 5%.
Coupon rate: the interest 'printed' on the bond
The coupon rate is the ratio of the annually promised interest based on the bond's face value. It's set at issuance and doesn't change until maturity.
For example, a bond with a face value of $10,000 and a 5% coupon rate pays $500 (=$10,000 × 5%) in interest each year. This $500 is fixed regardless of the price you bought the bond at.
So the coupon rate tells you 'how much interest this bond pays each year,' but it can differ from 'how much I actually earn.'
Yield to Maturity (YTM): the total return you actually earn
Yield to maturity (YTM) is the total return expected if you buy the bond at its current market price and hold it to maturity.
This includes not only the interest received each year but also the difference between the price you bought at and the face value returned at maturity (the capital gain or loss). Whereas the coupon rate looks only at interest, YTM reflects 'interest + price difference' together.
The key point is that the coupon rate is fixed, but YTM keeps changing whenever the market price moves. When a bond's price rises, its YTM falls; when the price falls, its YTM rises.
Par, discount, premium: three cases
The relationship between the price you bought the bond at and its face value determines the relative sizes of the coupon rate and YTM.
1. If you bought at par: coupon rate = YTM. You earn exactly what's printed.
2. If you bought below face value (at a discount): YTM > coupon rate. Since you'll get the full face value at maturity, the gain is added on, so the actual return is higher than the coupon rate.
3. If you bought above face value (at a premium): YTM < coupon rate. Since you'll get back less than you paid at maturity, a loss is added, so the actual return is lower than the coupon rate.
For example, if you bought a 5%-coupon bond below face value, the actual return (YTM) is higher than 5%; if you bought it above face value, it's lower than 5%.
So you shouldn't pick a bond by looking only at 'what % the coupon is.' Depending on the price you pay now, the actual return (YTM) changes. (Source: ICICI Direct, BondScanner, etc.)
Preguntas frecuentes
Q. Then why look at the coupon rate at all? Isn't YTM enough?
The coupon rate is still important because it tells you the 'interest that actually lands in your account each year (the cash flow).' For example, if you plan to use interest income for living expenses, the coupon rate is a direct concern. On the other hand, to compare the 'total return when held to maturity,' YTM is more accurate. The two are metrics with different purposes.
Q. If the YTM is high, is it always a good bond?
Not necessarily. An unusually high YTM means that bond's price is that much cheaper, and there may be a reason the price is cheap. If the price dropped because the issuing company's default risk grew, a high YTM may be a 'risk signal.' Don't look only at the yield; also consider the issuer's credit.
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