Currently, rates in the fixed income market are very low. As of September 13, the yield on the five-year Treasury note was close to 1.5 percent. In a low-rate environment in particular, it is critical to understand the differences between and the concepts of coupon rate, yield and expected return on fixed income securities.
Coupon Rate vs. Yield
The coupon rate of a fixed income security tells you the annual amount of interest paid by that security. For example, a Treasury bond with a coupon rate of 5 percent will pay you $50 per year per $1,000 of face value of the bond. The coupon rate, however, tells you very little about the yield of the fixed income security. For most securities, the yield is a good proxy for the return of the fixed income security (that is, how much you can expect your wealth to increase if you purchase the security) and is a far more meaningful piece of information than the coupon rate. To illustrate this, consider the following two Treasury bonds:
Yield vs. Expected Return
For most types of fixed income securities we purchase for our clients (for example, CDs, agency bonds and high-grade municipal bonds), yield is a good approximation of the actual return they are expected to earn. This is not true of all types of fixed income securities, however.
In particular, yield is not a good measure of the expected return for securities that have meaningful default risk, such as high-yield bonds, because the standard yield calculation assumes all principal and interest payments are certain to be received. The actual expected return for these types of fixed income securities will always be significantly lower than the yield. This also means the yields of securities with significant default risk cannot be meaningfully compared with the yields of securities with minimal default risk.