The Difference Between Coupon and Yield to Maturity

A Guide for Beginning Bond Investors

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Beginning bond investors have a significant learning curve but take heart. There's a lot to learn, but the difference between coupon and yield is a good place to start. It's onward and upward after you master this.

Coupon tells you what the bond paid when it was issued, but the yield – or “yield to maturity” – tells you how much you will be paid in the future. Here’s how it works.

Coupon Vs. Yield to Maturity

A bond has a variety of specific features when it's first issued, such as the size of the issue, the maturity date, and the initial coupon.

For example, the Treasury may issue a 30-year bond in 2017 that's due in 2047 with a “coupon” of 2 percent. It means that an investor who buys the bond and who owns it until face value can expect to receive 2 percent a year for the life of the bond, or $20 for every $1000 invested.

The bond trades in the open market, however, after it's issued. It means that its price will fluctuate over the course of each business day throughout the 30-year life of the bond. Now fast-forward ten years down the road. Interest rates have gone up in 2027, and new treasury bonds are being issued with yields of 4 percent.

If an investor could choose between a bond yielding 4 percent and the 2-percent bond, he would take the 4-percent bond every time. As a result, the basic laws of supply and demand cause the price of the bond with the 2-percent coupon to rise to a level where it will attract buyers.

Do the Math

Here’s where math comes into play.

Prices and yields move in opposite directions, so a move in the bond’s yield from 2 percent to 4 percent means that its price must fall. Keep in mind that the coupon is always 2 percent – that doesn’t change. The bond will always pay out that same $20 per year. But its price needs to decline to $500 – or in other words, $20 divided by $500 or 4 percent – for it to yield 4 percent.

So how does someone earn a 5 percent yield on a bond with a 2 percent coupon even in this situation? Simple: In addition to paying out the $20 each year, the investor will also benefit from the move in the bond price from $500 back to its original $1000 at maturity. Add the annual payment with the $500 principal increase – spread out over 20 years – and the combined effect is a yield of 5 percent. This yield is known as the yield to maturity.

It works the other way, too. Say prevailing rates fell from 2 percent to 1.5 percent over the first 10 years of the bond’s life. The bond’s price would need to rise to a level where that $20 annual payment brought the investor a yield of 1.5 percent – in this case, $1,333.33 because $20 divided by $1,333.33 equals 1.5 percent. Again, the 2-percent coupon falls to a 1.5-percent yield to maturity due to the decline in the bond’s price from $1333.33 to $1,000 over the final 20 years of the bond’s life.

The Bottom Line

High-coupon bonds have yields to maturity in line with other bonds on the table, but their prices are exceptionally high. When you're looking at an individual bond, it’s the yield to maturity and not the coupon, that counts because it shows what you will actually get paid.