Definition
Coupon refers to the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Yield refers to the income return on an investment, such as the interest or dividends received, usually expressed annually as a percentage based on the investment’s cost or current market value. It gets adjusted with the price of the bond whereas the coupon rate remains constant.
Key Takeaways
- The “Coupon” of a bond refers to the periodic interest payment that the bondholder receives while the bond matures. It’s the fixed amount of return bondholders can expect to receive and is usually expressed as a percentage of the bond’s face value.
- “Yield,” on the other hand, refers to the total return you can expect to receive if you retain the bond until it matures. Yield combines the bond’s annual interest payments and its capital appreciation or loss and is usually variable and dependent on market conditions.
- The relationship between coupon and yield is inversely proportional. When bond prices rise due to an increase in demand, the yield decreases but the coupon rate remains the same as it’s fixed. Conversely, when bond prices fall due to a lack of demand, the yield increases.
Importance
The finance terms: Coupon and Yield are integral to bond investing as they depict the return an investor can expect from their investment. Coupon refers to the annual interest rate paid on a bond, stated as a percentage of the face value.
It is a fixed percentage and does not change throughout the life of the bond. On the other hand, Yield is the annual return an investor receives from a bond.
Unlike a coupon, yield can change based on the market price of the bond. An understanding of both terms is vital because a bond’s yield can exceed its coupon rate when bond prices fall, and conversely, the yield can be lower than the coupon rate when bond prices rise.
Therefore, recognizing the contrast between these two terms can help investors maximize their returns and strategize their investment portfolio.
Explanation
Coupon and yield are two fundamental concepts in bond investing, which serve the purpose of providing the investor with a clear picture of the returns expected from their bond investments. The coupon rate, often simply referred to as the “coupon”, is the annual interest rate that the bond issuer promises to pay the bondholder.
Essentially, this is the fixed return that an investor will receive regardless of changes in market conditions or interest rates. It serves the purpose of attracting investors, indicating the regular income they can expect if they hold the bond until maturity.
On the other hand, the yield, specifically the yield to maturity (YTM), provides a more comprehensive understanding of the bond’s potential return. The yield takes into account both the annual coupon payments and the difference between the bond’s current market price and its face value.
Thus, it gives the investor an overall measure of return that includes periodic interest payments as well as any potential capital gains or losses upon maturity. This is particularly useful for investors who buy bonds in the secondary market at a price different from its face value, as it reflects the overall performance of the bond in different market scenarios.
Examples of Coupon vs Yield
U.S Treasury Bonds – These are debt securities issued by the U.S. government. The coupon is the fixed rate of interest the bond pays annually while the yield is what an investor anticipates can be earned on the bond over a particular timeframe. An investor could buy a $10,000 Treasury bond with a 5% coupon rate (meaning they receive $500 per year in interest) but if they bought it for just $9,500, the yield is higher because they’re earning $500 mainly on a $9,500 investment.
Corporate Bonds – A company may issue a bond with a coupon of 7% to attract investors. This is the fixed annual interest that investors will receive. However, if market interest rates rise to 8%, the bond’s price will likely fall, so it’s trading at a discount to entice new buyers. Despite the lower price, the coupon rate remains at 7%. Nonetheless, because the price of the bond is now lower, the yield to new investors would be higher than the initial coupon rate, adjusting the effective return of the bond closer to market interest rates.
Municipal Bonds – These are bonds issued by local governments to finance public projects. For instance, a city might issue a $100,000 bond with a coupon rate of 4%, so it pays $4,000 in interest annually. Suppose, five years later, interest rates have gone up and the bond’s market price has dropped to $95,
If a new investor buys the bond at this reduced price, their yield is now slightly about
2% ($4,000/$95,000), which is more attractive compared to the original coupon rate.
FAQ: Coupon vs Yield
What is a coupon in finance?
A coupon in finance refers to the annual interest rate that a bond’s issuer promises to pay to the bondholder on the bond’s face or par value. It is expressed as a percentage, and named after the historically physical coupon which needs to be clipped and sent to the bond issuer to receive the interest payment.
What is yield in finance?
Yield in finance usually refers to the earnings generated and realized on an investment over a particular period of time. It’s expressed as a percentage based on the invested amount, current market value, or face value of the security. It includes the income received from the investment as well as any change in value.
What is the difference between coupon and yield in finance?
The coupon rate is simply the rate of interest determined as a percentage of the face value of a bond to be paid annually. On the other hand, the yield of a bond is the overall return a bondholder gets on their investment, combining both the interest payments received annually, and the difference between the purchase price and the face value of the bond.
How does a coupon rate affect a bond’s yield?
When the coupon rate and yield are the same, the bond’s market price is equal to its face value. If the yield is higher than the coupon rate, the market price of the bond is less than its face value (discounted). If the yield is lower than the coupon rate, the market price is more than the face value (at premium).
Why is a bond’s yield greater than its coupon rate?
A bond’s yield is greater than its coupon rate when the bond is purchased at a discount to its face value. This happens when market interest rates are higher than the bond’s coupon rate. The bondholder not only receives the coupon payments, but also the additional value from the amortization of the discount, leading to a higher yield than the coupon rate.
Related Entrepreneurship Terms
- Bond Issuer
- Interest Rate Risk
- Face Value or Par Value
- Maturity Date
- Current Yield
Sources for More Information
- Investopedia: This is a reliable source of a wide range of topics related to finance, including Coupon vs Yield.
- The Balance: This site provides expert advice on personal finance, including detailed exploration of concepts like Coupon vs Yield.
- Corporate Finance Institute: This institution offers a wealth of information on financial terms and concepts, including detailed articles and learning resources on Coupon vs Yield.
- Financial Express: A comprehensive source for finance-related news and educational content, with in-depth articles explaining the difference between Coupon and Yield.
