The Difference Between Coupon and Yield to Maturity
A Guide for Beginning Bond Investors: Coupon vs. Yield to Maturity
Beginning bond investors have a significant learning curve ahead of them that can be pretty daunting, but they can take heart in knowing that it's manageable when it's taken in steps. There's a lot to learn, but the difference between coupon and yield to maturity is a good place to start. It's onward and upward after you master this.
In short, "coupon" tells you what the bond paid when it was issued. 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, including the size of the issue, the maturity date, and the initial coupon. For example, the U.S. Treasury might issue a 30-year bond in 2017 that's due in 2047 with a “coupon” of 2 percent. This means that an investor who buys the bond and who owns it until face value can expect to receive 2 percent per year for the life of the bond, or $20 for every $1000 he invested.
But then the bond trades in the open market after it's issued. This means that its actual price will fluctuate over the course of each business day throughout its 30-year lifespan. So now you have to fast-forward 10 years down the road. Let's say that interest rates go 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 a 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.
So in simplest terms, the coupon is the amount of fixed interest the bond will earn each year. Yield to maturity is the expected return if the bond is held until maturity.
Do the Math
Here’s where math comes into play. Prices and yields move in opposite directions. 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—$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, which is effectively a guesstimate of the average return over the bond during its remaining lifespan. As such, yield to maturity can be a critical component of bond valuation. A single discount rate applies to all as-yet-unearned interest payments.
It works the other way, too. Say prevailing rates fall 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, that would be $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.
Some Things to Keep in Mind When Calculating Yield to Maturity
Yield to maturity will be equal to coupon rate if an investor purchases the company's stock at par value.
Conversely, yield to maturity will be higher than the coupon rate when the bond is purchased at a discount.
High-coupon bonds have yields to maturity in line with other bonds on the table, but their prices are exceptionally high. It’s the yield to maturity and not the coupon that counts when you're looking at an individual bond because it shows what you will actually be paid.