YTM vs coupon rates:
In finance, a bond is a negotiable certificate that acknowledges the indebtedness of the bond issuer to the holder. It is negotiable because the ownership of the certificate can be transferred in the secondary market. It is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. Therefore, it is necessary to understand YTM and coupon rates, which are most of the time confusing. Therefore, this article aims at enlightening those who are still blind to the differences between YTM and coupon rates.
What is YTM?
The Yield to maturity (YTM) or redemption yield of a bond or other fixed-interest security, such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. The rate of return anticipated on a bond if it is held until the maturity date. YTM is considered a long-term bond yield expressed as an annual rate. The calculation of YTM takes into account the current market price, par value, coupon interest rate and time to maturity. It is also assumed that all coupons are reinvested at the same rate. Sometimes this is simply referred to as “yield” for short. The yield to maturity formula is used to calculate the yield on a bond based on its current price on the market. The yield to maturity formula looks at the effective yield of a bond based on compounding as opposed to the simple yield which is found using the dividend yield formula. The yield is usually quoted without making any allowance for tax paid by the investor on the return, and is then known as “gross redemption yield”. It also does not make any allowance for the dealing costs incurred by the purchaser (or seller).
What is a coupon rate?
The coupon rate of a bond is the amount of interest paid per year as a percentage of the face value or principal. The interest rate stated on a bond, note or other fixed income security, expressed as a percentage of the principal (face value) and it is also called coupon yield. The rate is set at the time the bond is issued and generally does not change. Most bonds make interest payments semi-annually, although some bonds are offered with monthly and quarterly payments. The term coupon rate used to have a much more literal meaning than it does today. To receive interest payments in the past, bondholders would have to clip a coupon from their physical certificate of bond ownership and take it to the bank to obtain the cash. Today, brokers are more likely to deposit the payments straight into the account of the consumer. Some bonds, known as zero-coupon bonds, do not pay coupons, and instead are sold at a price less than par value. Such bonds make only one payment: the payment of the face value on the maturity date. Normally, to compensate the bondholder for the time value of money, the price of a zero-coupon bond will always be less than its face value on any date before the maturity date.
What is the difference between YTM and coupon rate?
A bond’s coupon rate is the interest rate that is written into the terms of the bond indenture, and this value often appears on the bond certificate itself. The bond coupon rate is also referred to as the stated rate or the nominal rate of interest. On the other hand a bond’s yield to maturity is a measure that allows investors to account for all of the possible returns they will receive from the bond. This includes interest payments received, the possibility of reinvesting those interest payments, and the difference between the price paid for a bond (or market price) and the bond’s par value at maturity. The coupon rate is the actually stated interest rate. This is the rate earned on a NEW issue bond. The yield to maturity takes into consideration the purchase price of a bond bought in the secondary market.
Actually, YTM is a calculation that only approximates the true return. The coupon rate on the other hand is basically the rate of interest that a bond issuer, or debtor, will pay to the holder of the bond. Thus, the coupon rate determines the income that will be earned from the bond.The coupon rate is equal to the yield to maturity if the bond is sold at par. If the bond is a discount bond then the actual return on the bond includes amortizing the discount so your YTM includes both coupon interest and the amortization of principal. Thus it will be higher than the coupon rate. The opposite is true for premium bonds.
- YTM is the rate of return estimated on a bond if it is held until the maturity date, while the coupon rate is the amount of interest paid per year.
Coupon rate is expressed as a percentage of the face value of the bond.
YTM includes the coupon rate in its calculation.