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If you are an investor looking to explore the bond market, you might have encountered the terms “yield to maturity” and “coupon rate.” While these two metrics seem closely related, they serve distinct purposes in evaluating bond investments.
If you want to accurately evaluate a bond’s potential return, understanding their differences is vital. In today’s article, we will go through the concept of YTM vs. coupon rate and see how they differ.
What are YTM and coupon rates?
Understanding coupon rate
Bonds are an investment option with a fixed yearly payment and a fixed value at maturity, in contrast to stocks, whose prices might go up or down.
Bondholders receive interest payments from the issuer at a rate referred to as the coupon rate. It is usually showed as a percentage of the face value. For example, the interest payment for a bond with a coupon rate of 10% and a face value of ₹2,000 would be ₹200 per annum.
Imagine this as a steady stream of interest payments that accompany the bond to maturity, usually set at a particular rate.
Understanding yield to maturity (YTM)
A bond’s or other fixed-rate security’s yield to maturity (YTM) is its expected rate of return or interest when held speculatively. Other names for this rate include redemption yield and book yield.
The theory behind the yield to maturity is that a buyer acquires a security at the present price on the market, retains it until it reaches maturity (reaches its full value), and ensures that all interest and coupon payments are made on schedule.
Bonds are the only financial instruments that fall under this category, not stocks, since they don’t have a maturity date.
Interest is paid to bondholders via coupon payments. You must determine the YTM to assess and make a educated investment choice on the bond to buy.
By maintaining the original investment strategy and reinvesting coupon payments into the bond, yield to maturity determines the present value of the bond’s future coupons.
To calculate the YTM of a bond, you need to follow this formula:
Here,
C is the coupon payment or interest
FV is the face value
PV is the Present worth of the security
T is the time needed for maturity
Example:
Let’s say a bond’s face value is ₹2,000 and it has a 7% annual coupon rate, a market price of ₹1000, and a 10-year maturity period.
Annual interest = 2000 x 7% = 140
The YTM of the bond will be, in this case:
YTM = [₹140 + (₹2,000 – ₹1000) / 10] / [(₹2,000 + ₹1000) / 2] = 16%
The bond’s YTM is 16 per cent. This means, the investor stands to gain 16% annually from holding the bond till maturity.
What is the difference between YTM and coupon rate?
| Aspect | Yield to maturity | Coupon rate |
| Meaning | An investment return is the sum of all projected returns, including coupon payments and principal repayment, on a bond held to maturity. | The annual interest rate that the bond’s issuer will provide on the bond’s face value. |
| Payment | Using the bond’s present market value and remaining payments, it calculates the annualised rate of return. | Bondholders get fixed interest payments either once a year or twice a year. |
| Fluctuation | Fluctuates with changes in the bond’s market price and interest rates. | Remains constant throughout the bond’s tenure. |
| Investment return | Represents the investor’s actual earned rate of return, considering the present market value. | Does not change and does not reflect the bond’s market value. |
| Profitability | It is more profitable if the bond is purchased at a discount, as it includes price appreciation. | It remains the same until the bond’s maturity date. |
| Stability | Over time, it fluctuates in response to changes in the market, the price of bonds, and the amount of time until maturity. | The coupon rate represents stability, as it stays fixed till the bond’s maturity date, providing predictable interest payments. |
Conclusion
Identifying the differences between yield to maturity and coupon rate helps to clarify things for those who aren’t well-versed in finances. These are the two most essential phrases when investing in bonds. If you can get a good grasp of the critical differences, it will help you to get a thorough understanding of bond characteristics and potential investment outcomes.
FAQs
A higher Yield to Maturity (YTM) indicates a potentially better return on a bond if it is held until maturity, with all coupon payments made as scheduled and reinvested at the same rate. However, a higher YTM can also signal higher risk, such as credit risk or a bond priced below its par value. This could reflect compensation for potential risks or lower credit quality of the issuer. Investors should weigh the higher YTM against these associated risks.
Annual Percentage Yield (APY) pertains to deposit accounts like savings accounts or fixed deposits in India, reflecting the compounded interest earned annually. Yield to Maturity (YTM), on the other hand, is related to bonds and represents the total expected return if the bond is held to maturity. It includes all coupon payments and accounts for any gains or losses if the bond was purchased at a discount or premium to its face value.
In the Indian financial market, when interest rates rise, the price of existing bonds typically falls, which leads to an increase in YTM. This inverse relationship is due to the fact that new investors require a higher yield to compensate for the higher prevailing interest rates. Existing bonds must offer a competitive return to remain attractive, hence the increase in YTM to align with new interest rate levels.
In India, a higher coupon rate generally makes a bond more attractive as it offers a higher fixed income stream. However, the bond’s price may be higher in the secondary market, and the YTM could be affected by current market conditions. The decision between a higher or lower coupon rate depends on the investor’s income requirements, investment horizon, and existing interest rates in the market.
The coupon rate directly influences the yield to maturity (YTM). In the Indian bond market, if a bond is bought at a discount, the YTM will be higher than the coupon rate because the investor stands to gain from the price appreciation in addition to the coupon payments. Conversely, if a bond is bought at a premium, the YTM will be lower than the coupon rate as the investor pays more upfront for the bond, reducing the overall yield.