Bond Yield Rate vs. Coupon Rate: An Overview
A bond's coupon rate is the rate of interest it pays annually, while its yield is the rate of return it generates. A bond's coupon rate is expressed as a percentage of its par value. The par value is simply the face value of the bond or the value of the bond as stated by the issuing entity.
Thus, a $1,000 bond with a coupon rate of 6% pays $60 in interest annually and a $2,000 bond with a coupon rate of 6% pays $120 in interest annually.
Key Takeaways
- Coupon rates are the yields associated with regular interest payments made by bonds and are influenced by prevailing interest rates.
- A bond’s yield is the rate of return the bond generates.
- A bond’s coupon rate is the rate of interest that the bond pays annually.
- In addition, a bond's designated credit rating will influence its price and it can happen that when looking at a bond's price, you will find it does not reflect the relationship between other interest rates and the coupon rate at all.
- In order for the coupon rate, current yield, and yield to maturity to be the same, the bond’s price upon purchase must be equal to its par value.
Coupon Rate
Coupon rates are largely influenced by the interest rates set by the government. Therefore, if the government increases the minimum interest rate to 6%, then any pre-existing bonds with coupon rates below 6% lose value.
Anyone looking to sell pre-existing bonds must reduce their market price to compensate investors for the bonds' lower coupon payments relative to the newly issued bonds.
To buy a bond at a premium means to purchase it for more than its par value. To purchase a bond at a discount means paying less than its par value. Regardless of the purchase price, coupon payments remain the same.
To understand the full measure of a rate of return on a bond, check its yield to maturity.
Yield Rate
A bond's yield can be measured in a few different ways. The current yield compares the coupon rate to the current market price of the bond. Therefore, if a $1,000 bond with a 6% coupon rate sells for $1,000, then the current yield is also 6%; however, because the market price of bonds can fluctuate, it may be possible to purchase this bond for a price that is above or below $1,000.
If this same bond is purchased for $800, then the current yield becomes 7.5% because the $60 annual coupon payments represent a larger share of the purchase price.
Special Considerations
A more comprehensive measure of a bond's rate of return is its yield to maturity (YTM). Since it is possible to generate profit or loss by purchasing bonds below or above par, this yield calculation takes into account the effect of the purchase price on the total rate of return. If a bond's purchase price is equal to its par value, then the coupon rate, current yield, and yield to maturity are the same.
When discussing bonds, it is important to note the many different types of yield rates out there. For the purposes of this article, we focused mainly on the current yield. But depending on the situation, it may be more appropriate to use yield to maturity, annual percentage yield (APY), yield to worst (YTW), yield to call, the bond equivalent yield (BEY), or effective annual yield. A good understanding of each and when to use them is useful when evaluating bonds.
What Does It Mean If the Coupon Rate Is Higher Than the Yield?
If the coupon rate on a bond is higher than its yield, the bond will be trading at a premium. This is because the fixed rate of interest on the bond exceeds prevailing interest rates; therefore, people will pay a premium to earn those higher coupon payments. This is why bond prices fluctuate inversely with interest rates. As interest rates fall, the bond price rises.
What Is the Difference Between Coupon Rate and Interest Rate?
The coupon rate is the interest rate paid by a bond relative to its par or face value. For a fixed-rate bond, this will be the same for its entire maturity. Prevailing interest rates may rise or fall in the meantime, which would instead affect the price of the bond (given its fixed coupon rate). In general, a bond's coupon rate will be comparable with prevailing interest rates when it is first issued.
How Do You Calculate Yield Rate?
A bond's yield, or coupon rate, is computed by dividing its coupon payment by its face value. An updated yield rate can be computed by dividing its coupon by the current market price of the bond.
The Bottom Line
Coupon rates and yields are two important components of a bond that go hand in hand. The coupon rate is the annual interest rate of the bond, which affects the market price of the bond. This in turn impacts the yield of the bond, which is the amount of return generated. Both are important factors to consider when analyzing a bond investment.
