What is the Difference Between Coupon and Yield?
Coupon and yield are important concepts in the world of bond and fixed-income investment. The coupon is the fixed interest paid by the issuer to the bondholder. It is expressed as a percentage of the bond’s face value. This payment is made unconditionally throughout the bond’s term. As a result, it provides a stable income stream for the bondholder.
On the other hand, yield means the actual return an investor earns from a bond. The yield fluctuates with the current market price and prevailing interest rates. This relationship between coupon and yield is very crucial to understanding how the bonds are valued and traded in the market. In this article, you will learn about the differences between coupon and yield, how each affects bond pricing, and the implications these factors have for investors.
Key Takeaways
- Coupon is the fixed interest paid by the bond issuer, while yield reflects the actual return an investor earns, based on market price and interest rates.
- The coupon rate remains constant throughout the lifetime, whereas yield actually fluctuates in accordance with the market conditions and pricing of bonds.
- If a bond’s yield is higher than its coupon rate, it means that the bond is trading at a discount in the secondary market.
- Prices and yields of bonds are negatively related, meaning that when one goes up, the other goes down.
Table of Contents
Coupon Vs. Yield
The differences between coupon and yield are explained below:
| Aspect | Coupon Rate | Yield to Maturity (YTM) |
| Definition | The fixed interest rate is paid to bondholders by the issuer until maturity. | The total return an investor earns if the bond is held until maturity, including all interest payments and the repayment of principal. |
| Stability | It remains constant throughout the life of the bond. | It fluctuates based on the current market price and the remaining years until maturity. |
| Payment Frequency | Typically paid annually (or semi-annually). | Represents an annualised return based on total returns until maturity. |
| Interest Rate Relation | It does not fluctuate; it remains fixed regardless of market conditions. | Compares the coupon rate to the bond’s current market price, reflecting market conditions. |
| Impact of Market Price | The coupon amount remains the same until maturity. | YTM changes with fluctuations in market price; purchasing a bond at a discount can increase YTM significantly. |
| Calculation Basis | Based on the bond’s face value and fixed interest payments. | It is calculated using the bond’s current market price, coupon payments, and time remaining until maturity. |
| Investor Perspective | Indicates the income generated from holding the bond. | Provides insight into the total expected return if held to maturity, considering all cash flows. |
Effect of Coupon and Yield on Bond Price
A bond’s coupon rate represents the percentage of its face value that the bond pays in interest. In contrast, the bond’s yield reflects the actual return an investor receives. One might assume that high coupon rates and high yields are ideal, but they both influence the bond’s price in the same inverse manner: as one increases, the other decreases.
A bond that offers a higher rate (coupon) will most likely be more expensive than the equivalent bond with a lower rate. However, if bond values rise, the higher-yielding bonds will become relatively cheaper, as they appreciate less than the lower-yielding bonds. The lower price will likely attract more investors.
Coupons and yields are inversely related in that one increases while the other decreases, and vice versa.
The yield can be used to compare different investments that have the same coupon rate. It is important that one knows how to calculate the price of a bond to discover the break-even yield, this will allow one to figure out if the bond is a good investment for them.
Formula:
Bond Price = Coupon Rate / (1 + YTM)^n + Par Value / (1+YTM)^n
Thus, coupon rate and yield are inversely related. Higher coupon rates result in a decline in the price of a bond, whereas yields make the price of bonds go up.
Conclusion
Understanding the difference between coupon and yield is essential for investors in the bond market. While the coupon is a stable income type, the yield permits insight into real return changing with bond prices and market movement. Though distinct, these two factors are related and vital in assessing the overall value of a bond. Knowing how a coupon interacts with the yield can give investors a better sense of what to do next in their fixed-income portfolios.
FAQs on the Difference Between Coupon and Yield
The yield of a bond will often be different from the original yield at the time of issue. When the yield of a bond differs from the coupon rate, then the bond is either at a premium or discount to keep pace with changes in market conditions. Even though the coupon rate remains fixed, the yield of the bond will fluctuate due to changing prices.
If a bond's yield is higher than its coupon rate, it means that the bond is trading at a discount in the secondary market. This is due to the rise of prevailing interest rates over and above the bonds fixed coupon payments; therefore, making new bonds with higher coupon rates attractive to new investors. The price of existing bonds falls to compensate for lower coupon payments.
The coupon or coupon rate refers to the amount of interest paid on a bond, debenture, or fixed-interest security. This coupon payment is made annually against the face value of the bond. The company that issues the bond will make the coupon payments to the bondholder. The yield is defined as the effective interest rate for the bond or debenture. The yield will move inversely to the market price of the bond.