What is the difference between coupon and yield?

The coupon rate is the annualized interest amount. It is the percentage of the face value that a bond pays in one year. The coupon rate is calculated by taking the annual coupon payment and dividing it by the bond’s face value.

A coupon bond is a bond with a fixed interest rate, or coupon. You can calculate how much interest you will receive from your investment by multiplying the bond’s face value by its coupon rate and then dividing by 100. For example, if you own a Rs 1,000 par value bond with an 8% annual coupon payment, your annual interest would be Rs 80 (Rs 1,000 x 0.08 = 80).

The difference between coupon and yield is that coupon refers to the stated interest rate payable each year, while yield refers to the actual return an investor earns from holding a bond for a year.

Investors should always be careful when examining bond data as another difference between coupon and yield is that coupon is fixed, whereas yield can change over time. Thus, investors depend on books and other outlets to provide accurate information regarding both variables.

The coupon rate and yield to maturity

The coupon rate and yield to maturity are two key terms of bonds. They might be used interchangeably, but they each have a different meaning. The coupon rate is the stated interest rate on a bond. So, if you buy a bond with a coupon rate of 4%, that means that you’ll receive an annual interest of 4% of the face value for however long you hold onto the bond (unless it gets called). The yield to maturity (YTM) is the actual return that’s earned based on the current market price of the bond. Yield refers to the amount you earn if you could hang onto this particular bond until it reaches maturity or gets called.

However, If there are changes in inflation or interest rates after a bond has been issued, its price will go up or down, depending on whether inflation and interest rates rose/fell above/below the original coupon rate. In other words, if inflation goes down and so do interest rates. Your newly-issued Rs 1,000 bond will become more valuable than before since most people won’t be buying new bonds at this lower rate while they keep cashing out their old higher-interest bonds. Consequently, your yield will go down as well because your new Rs 1,000 bond will now pay less than other higher-coupon bonds still being issued by others.

Effect of coupon and yield on bond price

Bond coupon vs yield

A bond’s coupon is a per cent rate of its face value, while yield is the return an investor receives. You might think that high coupon and high yield would be ideal, but they both influence bond price in the same way: when one goes up, the other goes down. If a bond pays high interest (coupon), you’d expect it to be more expensive than bonds with a lower interest rate. But, what about if bond prices go up? In that case, higher-yielding bonds would be cheaper since their price increased less than lower-yielding bonds—and after all, cheaper bonds are more attractive to investors.

The bottom line for coupon rates vs yield is that both of these are inversely related. As one increases or decreases, so does the other.

Yield can also be used to compare different investments that have the same coupon rate. This is an important skill since you'll need to know how to find the price of a bond to determine its break-even yield, which you may want to do if you're considering whether a bond is worth purchasing.

Formula:

Bond Price = Coupon Rate / (1 + YTM)^n + Par Value / (1+YTM)^n

This formula shows that the relationship between coupon rate and yield is inverse. If coupon rates increase, then the price of the bond decreases; conversely, if yields rise, then the price of bonds will increase.

Some Things to Keep in Mind When Calculating Yield to Maturity

An individual bond investor sees the coupon payment as a source of profit, whereas a bond trader sees potential gain or loss generated by variations in the bond's market price.

If an investor purchases the bond at the original price (Par value), the yield to maturity will be equal to the coupon rate. Hence, you need to pay attention to the coupon rate if you plan on buying a new-issue bond and holding it till maturity. However, if you bought a bond at a discount, the yield to maturity will be higher than the coupon rate. Adversely, in the case of a bond purchased at a premium, the yield to maturity will be lower than the coupon rate.