What is the difference between coupon rate and yield to maturity?
Topics covered in the article:
- What is coupon rate?
- What is yield to maturity?
- Distinguish between coupon rate and yield to maturity
- Wrapping up
To begin, let us first understand what coupon rates are.
The coupon rate is the interest paid out to the bearer of a bond by the issuer over time. It is expressed in percentage terms as a share of the face value. For instance, if a bond has a face value of Rs. 1,000 and a coupon rate of 10%, then the annual interest payment would be Rs. 100 (10% of Rs. 1,000).
The coupon rate represents the annual interest rate paid by the bond with respect to the face value. It is more like a fixed-income security for the government in which the issuer of the bond acquires yearly interest payments. For instance, a company issues a bond with a face of Rs. 20000. For this bond, the rate of interest is fixed at 20% per annum. Here, the 10% per annum is the coupon rate. When investing an amount of Rs. 20000 in the bond, they shall receive an amount of Rs. 4000 per annum as interest payment.
The coupon rate on ICICI Bank’s fixed-rate bonds is currently 7.75%, while for floating-rate bonds, it is 9%. The Indian government offers multiple bonds, each with different coupon rates.
The RBI also offers bonds with variable coupon rates. For example, the 7.15% RBI Bond maturing in 2025 has a variable coupon rate which is reset every six months. For the period of July 1, 2022, to December 31, 2022, the coupon rate on Floating Rate Service Bonds 2020 (taxable) payable amount is 7.15%.
What is yield to maturity?
The yield to maturity is the percentage rate of return that bondholders will receive if they hold the bond till the time it matures. The yield to maturity becomes relevant when an investor purchases a bond from the secondary market. This rate takes into account the interest payments that have already been made, as well as any capital gains or losses that may occur over the life of the bond.
The yield to maturity is essential because it represents the return on their investment.
The formula used to sum the yield of maturity of the bond-
YTM = (annual interest payment) + (face value - current trading price) divided by (remaining years of maturity) divided by (face value + current price) divided by 2.
Understanding, with an example, an investor is holding a bond with a face value of Rs. 10000 and a coupon rate of 10%. Assuming the bond is to be traded on the market currently at Rs. 9200. If we suppose that five are remaining for the bond's maturity to get over, with interest paid out twice a year.
The yield of maturity of such a bond is (1000 + (10000 - 9200) divided by 5 divided by (10000 + 9200) divided by 2 = 0.1208 or 12.08%.
Distinguish between coupon rate and yield to maturity
The primary difference between a coupon rate and yield to maturity is that the coupon rate has fixed bond tenure throughout the year. On the contrary, the yield to maturity keeps changing depending on multiple factors, such as the current price at which the bond is being traded and the remaining years till maturity.
The coupon rate is the amount paid to the bondholder by the issuer until its date of maturity. On the other hand, the yield of maturity is the total return earned by the investor till its maturity.
In a coupon rate, the rate of interest is paid annually. In contrast, the yield of maturity defines the return it generates annually.
In a coupon rate, the interest rate fluctuates. On the other hand, the yield to maturity compares the coupon rate to the market price of the bond.
In a coupon rate, the coupon amount remains the same till the date of its maturity. In the yield to maturity, the market price keeps changing, due to which it is considerably more profitable to purchase a bond at a discount which represents a large share of the purchased price.
Coupon rate can be explained as the interest rate paid on the bond's value by the bond issuer.
The yield to maturity, on the other hand, is actually the rate of return that an investor receives when the bond matures. It is the total rate of return that shall be earned by a bond when it makes all interest payments and repays the original principal.
The primary distinction is that the coupon rate continues to remain the same throughout the duration of the bond. In contrast; the yield to maturity fluctuates in rates based on various conditions, including those that remain till maturity.
The primary purpose of distinguishing between the coupon rate and yield to maturity is to clear the terms for people having limited experience in the financial sector. These two terms are considered major for managing and operating bonds.
In addition, combining these will help you to reap returns and translate into the concept of higher coupon rates which means higher yield.
Apart from the usage in bonds, the terms coupon rate and yield to maturity are both different from each other.
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