Quick Take on Fixed Income
Q: What is the difference between a bond’s coupon rate and yield to maturity?
A: The coupon rate tells you the annual amount of interest paid by a fixed income 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. 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 far more meaningful than the coupon rate. To illustrate, consider these two Treasury bonds:
Both bonds mature around the same time, but they have enormous differences in coupon. One is paying coupon interest of $88.75 per year per $1,000 of face value and the other is paying $27.50, yet one trades at a yield to maturity of 2.40 percent and the other at 2.41 percent. This means they are priced in a way to provide essentially the same return. You have to pay significantly more to buy the bond with the relatively high coupon than the bond with the lower coupon. The net result is that either purchase has essentially the same yield to maturity, or expected return.
Another measure of yield that sometimes can be referenced is current yield, which is calculated by dividing a bond’s annual cash flow by its current price. This measure is not an accurate reflection of the actual return that you will receive because it only takes into account the coupon and current price as opposed to yield to maturity, which takes into account those two factors as well as the par value and time to maturity, providing a more complete picture. There are some brokers who will quote current yield as opposed to yield to maturity because the current yield is typically higher.
For example, let’s say a Texas water bond with a coupon of 6.25 percent and a maturity date of June 2021 is currently trading at 126.686. At that price, the current yield is 4.93 percent while the actual yield to maturity is only 1.63 percent.
When considering fixed income options, it is important to understand the differences among coupon rate, yield and expected return. While each piece does tell an important story, the best indicator of return on the security is yield to maturity.
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