The Set Rate of Payment on a Bond
In short:
Coupon rate is the annual rate of return, or yield, paid on a fixed-income security such as a bond. This value is a percentage reflection of the sum of annual payments of a fixed-income security in relation to the original issue price, called the par or face value. It is important to note, the coupon rate does not change after the security is issued.
Key Points
- Coupon rate is the initial interest rate of a bond.
- The coupon rate is a fixed rate that does not change.
- Coupon rates are relative to the face value of a fixed-income security.
- Though coupon rate doesn’t change, current yield and yield to maturity do change.
In-depth:
Coupon vs Coupon Rate
So, what’s the difference between a coupon and a coupon rate? A coupon is simply the cash payment made to the holder of the bond. A coupon rate is the percentage value of that cash payment relative to the face value of the bond.
For example, say we had a bond with a face value of $1,000 and it paid us an annual coupon of $25. The coupon for this bond would be $25/year while the coupon rate would be $25/$1,000 or 2.5%. The coupon rate is the percentage value.
Now, coupons can be paid to bondholders any number of times per year such as annual (once), semi-annual (twice), quarterly (four times), and so on. If this is the case we need to adjust how we view the coupon rate slightly since we may receive smaller coupons more times.
Let’s say we now have the same bond as above but get paid semi-annually. The annual coupon value is still $25 but we receive it in two payments. In this case, our coupon value is $12.5 but our coupon rate is still 2.5% since the coupon rate is the annual sum of coupon payments divided by the face value of the bond.
Formula:
Market Effect on Coupon Rate
What happens if the market value of the bond changes or if interest rates change? This is where the coupon rate loses its value as a measure of true return for fixed-income investors. Since the coupon rate is fixed, that is it doesn’t change, it may not reflect what you would actually earn by buying and holding the bond.
Why is this the case?
Bonds are priced on a number of different factors, one of those factors is what the current interest rate environment looks like. If interest rates are high when the bond is issued, then it is likely that the bond will likely also have a high coupon rate.
For example, if interest rates fall the bond may be paying a higher interest rate than the average of the new environment since coupon rates never change. To account for this, the price of the bond will change, going up in the case of declining interest rates. The change in trading price of the bond will offset the higher coupon rate the bond is paying since the investor is paying more for the same coupon as before.
We can also reverse the scenario from above. If interest rates are rising, then the price of the bond will fall to offset an account for the change in average interest rates.
Investors can account for these changes and calculate the effective yield, i.e. interest rate, of a bond by either calculating the bond’s “current yield” or its “yield to maturity”.
Coupon Rate vs Current Yield
Current yield is the expected rate of return on a bond or fixed-rate security that is bought and held for one year. While coupon rates are fixed and do not change, current yields are always subject to change. An investor using current yield is unlikely to hold onto a bond for a long period of time.
The reason current yield is used is that bonds typically do not trade at their face value after they are issued. Normally bonds will trade above, called trading at a premium, or below, called trading at a discount as we hinted at above. When the bond trades at a different price than the face value of the bond, the effective yield of a bond will be different than its stated yield.
For example, if a bond has a face value of $1,000 and annual coupons of $75 then the stated yield of the bond is 7.5% ( $75/$1,000 ). Now if the bond trades at a discount to par (face value) its yield will increase. Say the bond now trades at $900, the current yield is 8.3% ( $75/$900 ). Conversely, if the bond trades at a premium to par, say $1,100 the current yield would decrease to 6.8% ( $75/$1,100 ).
Formula:
Coupon Rate vs Yield to Maturity
Yield to Maturity (YTM) is the expected rate of return on a bond or fixed-rate security that is held to maturity. Since bonds do not always trade at face value, YTM gives investors a method to calculate the yield they can expect to earn on a bond if they held it until redemption.
Assumptions of YTM are that the investor holds the bond until its maturity date, all coupon payments are made in full and on time, and all coupons are quickly reinvested at the same rate of return. In practice, reinvesting coupon payments at the same rate of return will likely prove difficult so YTM may only give an investor a general yield idea and metric for comparison.
Additionally, YTM accounts for the time value of money. That is, money today is worth more than money tomorrow. This is especially important for long-term bonds since the maturity date may be 10, 20, or 30 years from the purchase.
Calculating YTM by hand is often not practical as it can be difficult and time-consuming. However, the formula for YTM which demonstrates the idea behind the calculation is below:
If you’re looking for more information on yield to maturity or how to calculate it in excel, we have two articles that specifically address these topics in detail.
Resource: Yield to Maturity
Resource: Calculating Yield to Maturity in Excel
Frequently Asked Questions
Current yield shows an investor the rate of return they can expect to receive by buying a bond at its current price and holding it for one year. The meaning behind the current yield is to express the effective one-year interest rate on a bond.
Current yield is simply the interest rate an investor would earn if they bought the bond at market price today and held it for one year. Yield to maturity is the effective interest rate an investor would earn by holding the bond until maturity. The difference between current yield and yield to maturity is that current yield does not account for the present value of future cash inflows of the bond.
Nominal yield is the coupon rate of a bond, this is a fixed value. Current yield is the effective one-year yield on a bond, this value can and often does change. Current yield and nominal yield are not the same, in that they refer to different things.