Differences Between Coupon Rate and Yield: All You Need to Know
Key Takeaways:
Coupon rate and yield are two terms that are important to know when you’re investing in bonds. They highlight different aspects of performance and are used to make informed decisions in the fixed-income market.
Understanding these concepts helps in comparing bonds, evaluating potential returns, and identifying risks. A clear understanding of coupon rate and yield allows you to interpret bond investments effectively and align them with your financial goals.
What is the Coupon Rate?
Coupon rate means the fixed annual interest rate that a bond issuer agrees to pay its bondholders, as a percentage of the bond’s face value. The interest rate is determined at the time of issuance and generally remains unchanged, regardless of market fluctuations.
For investors, the coupon rate acts as a predictable income source, much like a steady salary. This makes it an important factor in evaluating bonds as part of a fixed-income portfolio.
For example, let’s say the Government of India issues a bond with a face value of ₹10,000 and a coupon rate of 7%. Here, you, as an investor, will receive ₹700 annually as interest.
How is Coupon Rate Calculated?
The coupon rate is calculated by comparing the total interest paid in a year to its face (par) value. First, identify how much the issuer pays you each year. Then, add up all coupon cheques if they are semi-annual or quarterly. Next, divide that annual coupon amount by the bond’s face value and express the result as a percentage. This rate is fixed at issuance and does not change with day-to-day market prices.
Coupon Payment = Original Face Value x Coupon Rate
Coupon Rate = (Annual Coupon Payment / Original Face Value) x 100
For example, say a Government of India security has a face value of ₹1Lakh and pays ₹3,600 every six months. The annual coupon payment here becomes ₹3,600 × 2 = ₹7,200.
Divide by the face value to get ₹7,200 / ₹1,00,000 = 0.072, i.e., a 7.20% coupon rate.
Fixed Coupon Rate vs Variable Coupon Rate
Here is a clear difference between coupon rate and yield to maturity in tabular format:
| Aspect | Fixed Coupon Rate | Variable Coupon Rate |
|---|---|---|
| Interest Payment<br> | Remains constant throughout the bond’s life | Fluctuates based on market benchmarks (e.g., RBI Repo Rate) |
| Predictability | Highly predictable, making it easy to plan future income | Less predictable, as payments change with market conditions |
| Suitability | Best for conservative investors seeking stability and steady returns | Suitable for investors willing to take risks for potentially higher returns |
| Impact of Market Rates | Bond prices may fall when market interest rates rise | Payments increase if interest rates rise, offering a hedge against inflation |
| Risk Level | Lower risk due to the certainty of income | Slightly higher risk due to uncertainty in future returns |
What is Yield to Maturity (YTM)?
Yield to Maturity (YTM) means the total rate of return you can expect if you hold a bond until it matures. Unlike the coupon rate, YTM factors in the bond’s current market price, coupon payments, time to maturity, and any capital gain or loss. It represents the true earning potential of the bond over its lifetime.
YTM is significant because it provides a comprehensive measure of the bond’s profitability. It gives you the return on investment by considering how much you paid for the bond in the secondary market.
For long-term investors, YTM acts as a benchmark that reflects both income stability and market fluctuations. It helps you assess whether a bond is worth holding until maturity.
The coupon rate is fixed at issuance and shows the interest relative to the bond’s face value.
On the other hand, the YTM changes depending on the bond’s current trading price, making it a more dynamic and realistic measure of returns.
How is YTM Calculated?
YTM is calculated by combining the annual coupon payments with any gain or loss made if the bond is bought at a discount. Unlike the coupon rate, YTM adjusts to reflect the bond’s current market price, making it a more accurate reflection of real returns.
Yield to Maturity (YTM) = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]
Where:
Annual Interest = Annual coupon payment from the bond
FV = Face value (the redemption amount)
Price = Current market price of the bond
Maturity = Years remaining until the bond matures
For example, say you purchase a government bond with the following details:
Face Value (FV): ₹1,000
Coupon Rate: 8% (Annual Interest = ₹80)
Current Market Price: ₹900 (bond trading at a discount)
Maturity: 5 years
After putting the values in the formula, the YTM comes to 0.1052, which is 10.52%. This means that even though the coupon rate is 8%, buying the bond at a discount increases the return to 10.52% if held till maturity.
Key Differences Between Coupon Rate and Yield to Maturity
Both coupon rate and YTM are important measures in bond investing, but they focus on different aspects of return. The coupon rate reflects the fixed interest set at issuance, while YTM considers the total expected return if held until maturity. Here are the core differences between coupon and yield:
| Aspect | Coupon Rate | Yield to Maturity (YTM) |
|---|---|---|
| Meaning | Fixed annual interest rate on the bond’s face value set by the issuer. | Total return expected if the bond is held to maturity, considering price and interest. |
| Depends On | Face value of the bond. | Current market price, coupon payments, and time to maturity. |
| Stability | Remains constant throughout the bond’s life. | Fluctuates with market conditions and bond prices. |
| Set By | Issuer at the time of issuance. | Determined by market trading and investor demand. |
| Investor Insight | Shows fixed interest income promised annually. | Shows the actual return you can expect in present market conditions. |
| Market Relation | Does not change with bond price movements. | Moves inversely with bond prices. |
Impact of Market Price on Yield and Coupon
The coupon rate is fixed and does not change with market movements, as it is based on the face value. You receive the same coupon payment, regardless of whether the bond’s price rises or falls in the secondary market.
This makes coupon payments predictable but does not reflect the real-time return if you buy or sell the bond at a different price.
The yield, however, is highly sensitive to changes in the bond’s market price and interest rate. When interest rates rise, new bonds are issued with higher returns. It leads to a fall in the prices of existing bonds and pushes their yields upward.
Conversely, when interest rates fall, older bonds with higher coupon payments become more attractive, causing their prices to rise and yields to decline. This inverse relationship is central to bond investing, as it helps you evaluate whether to hold, buy, or sell bonds.
Why YTM Can Be Higher or Lower than the Coupon Rate?
YTM can be higher than the coupon rate when a bond is purchased at a discount. It means the market price is below the face value. In this case, you earn the fixed coupon payments and gain additional profit when the bond matures at par. It boosts the overall return above the coupon rate.
Alternatively, YTM becomes lower than the coupon rate when a bond is bought at a premium, i.e., above face value. Even though you continue to receive the fixed coupon payments, part of the investment is lost when the bond is redeemed at par.
It reduces the overall return compared to the coupon rate. If a bond is purchased at face value, YTM and the coupon rate will be equal.
Why Understanding Coupon Rate and Yield Matters for Indian Investors
For Indian investors, the coupon rate is important to understand. It shows the fixed annual income from a bond, helping plan predictable cash flows and manage risk. It is especially relevant for government securities, tax-free, and corporate bonds.
The YTM goes further by showing the actual return considering market price, coupon payments, and time to maturity. In India’s changing interest rate environment, YTM helps compare bonds and choose the best opportunities for stable yet rewarding returns.
Frequently Asked Questions
Can the coupon rate change after a bond is issued?
No, the coupon rate cannot change once a bond is issued, as it remains fixed for the life of the bond. However, the bond’s yield can change, as it depends on the market price and interest rate movements.
How does inflation affect bond yield and coupon payments?
Inflation does not change fixed coupon payments, but it reduces their real purchasing power. As a result, bond prices usually fall and yields rise to compensate investors for higher inflation risk.
What happens to the yield and coupon rate if the bond is called early?
If a bond is called early, the coupon rate stays unchanged. However, the yield shifts to Yield to Call (YTC), calculated up to the call date. YTC is often lower than the original Yield to Maturity (YTM), especially when issuers refinance at lower rates.
Is yield to maturity a guaranteed return?
No, Yield to Maturity (YTM) is not a guaranteed return. It is only an estimate based on assumptions like holding the bond till maturity and reinvesting coupons at the same rate.
How do taxes impact returns from coupon payments and yield?
Taxes reduce the actual income from coupon payments and lower the effective yield. This is because interest earned on most bonds is treated as taxable income. The impact depends on your tax slab and whether the bond is taxable or tax-free.
Can I compare the YTM of different bonds directly?
Yes, you can compare the YTM of different bonds, as it gives a standardised measure of total return. It has limitations, as it assumes reinvestment at the same rate and does not factor in taxes, costs, or credit risk.