Expected yield vs initial fixed yield
In short:
Yield to maturity and coupon rate are both used with fixed-income securities such as bonds but are different in what they measure. The high-level difference is that the coupon rate is set when the bond is first offered by the issuer and does not change. While yield to maturity is calculated by the investor later on and can change depending on the current market price of the bond.
More specifically:
Yield to Maturity (YTM) is the expected rate of return on a bond or fixed-rate security that is bought by an investor and 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.
Coupon rate is a fixed value in relation to the face value of a bond. 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.
- Yield to Maturity, is the expected return of a bond if bought and held until maturity.
- Yield to Maturity can and often does change with time.
In-depth:
Coupon Rate details
When bonds are initially offered, they need to be offered with some type of yield (interest rate) attached to them at their offering. Since most bonds are coupon bonds, meaning they pay some sort of annual interest, they are given a coupon rate. That is, the annual sum of cash payments of the bond are divided by the face value (par value) to establish the interest rate of the bond, i.e. the coupon rate.
This rate will be what the issuer of the bond will annually pay the holder of the bond no matter if the bond is sold.
For example, say a bond is issued with a face value of $1,000 and an annual coupon of $75. The coupon rate for this bond is then 7.5% ( $75 / $1,000 ). Now if time passes and the bond is sold by the original investor to another investor for $900, the coupon rate will still be 7.5% and the annual coupon payment is still $75.
This is because the bond issuer is obligated to pay $75 annually on the initial $1,000 investment until the bond reaches maturity.
You may have noticed the investor who bought the bond at $900 is actually making $75 per year with their $900 investment instead of needing to invest $1,000. Since they are making the same dollar amount with less cash invested their effective interest rate is higher. This is where yield to maturity comes in.
Yield to Maturity details
When bonds trade at a different price than their face value the coupon rate will no longer reflect the effective yield an investor will receive on the bond. In this case, investors need a way to calculate their return on investment. Luckily, investors have two options for calculating a bond’s yield. They can calculate its current yield or its yield to maturity (YTM).
If the investor intends to hold the bond for a long period of time, the investor will likely calculate the YTM which is the long-term rate of return.
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, 30 years from the purchase.
The YTM calculation is complex and can be very involved to do by hand. Here are two articles that explain YTM in more depth and how to calculate it: What is Yield to Maturity and Calculating Yield to Maturity in Excel.
Frequently Asked Questions
Yield to Maturity (YTM) is the expected rate of return on a bond or fixed-rate security that is bought by an investor and held to maturity. Coupon rate is a fixed value in relation to the face value of a bond.
If yield to maturity is greater than the coupon rate, the bond is trading at a discount to its par value. If the yield to maturity is lower than the coupon rate then the bond is trading at a premium to its par value. If yield to maturity and coupon rate are equal, then the bond is at par value.
The coupon rate is the initial interest rate of the bond when issued at face value. Coupon rate, however, is not always the effective interest rate of a bond when the current price is different from the face value.