Coupon Rate vs Yield to Maturity: Key Differences Explained

Investing in bonds often requires understanding a range of financial terms. Two of the most frequently encountered are the bond’s coupon rate and yield to maturity (YTM). Though they are both associated with bond returns, there is a difference between coupon rate and yield.

The coupon rate tells you how much income a bond pays annually, while YTM reflects the total return if you hold the bond until it matures. 

The first step in understanding coupon rates requires explaining what they mean. A bond's coupon rate represents the yearly interest payments that bond issuers provide to you. 

The bond's coupon rate exists as a percentage value based on its face value, which is also known as its par value. Throughout the entire bond duration, this rate remains unchanged. 

For example, if you buy a bond with a face value of ₹1,000 and a coupon rate of 8%, you will receive ₹80 annually as interest.

Coupon Rate Formula:

Coupon Rate = (Annual Interest Amount / Face Value of Bond) × 100 

This fixed return component is ideal for those looking for predictable income over time.

Now, let us look at what YTM is in bond investments. Yield to Maturity (YTM) represents the overall rate of return you can anticipate earning if you retain the bond until it matures. It takes into account any of the following:

• The bond’s market price at the time of purchase

• Regular interest payouts

• The gain or loss between the acquisition cost and its face value

YTM considers that:

• The bond is held till maturity

• All coupon payments are reinvested at a rate equal to the bond’s yield to maturity

• YTM is dynamic and adjusts to changes in bond prices and market interest rates.

Simplified YTM Formula:

YTM = [Coupon Payment + (Face Value - Current Price) ÷ Number of Years to maturity] ÷ [(Face Value + Current Price) ÷ 2] × 100

Note: The actual calculation involves solving for the interest rate in a present value equation.

To better understand their practical significance, here is how they differ in purpose and behaviour. 

Coupon Rate: Provides a fixed return on face value and doesn't change with market conditions.

YTM: Reflects actual yield based on current price and reinvestment assumptions. 

Example:

If a bond with a 10% coupon is trading at par (₹1,000), then YTM = 10%

If the same bond trades at ₹950, YTM becomes greater than 10% (you pay less but receive the same ₹100 coupon). If the bond trades at ₹1,050, YTM becomes less than 10%.

This shows how YTM adjusts based on bond price fluctuations.

Formula and Calculation

Let us break down the core formula used to calculate YTM:

YTM = [C + (F - P) ÷ n] ÷ [(F + P) ÷ 2] × 100

Where:

C = Annual coupon payment

F = Face value of bond

P = Purchase price of bond

n = Number of years until maturity

This approximation provides a quick estimation of YTM, though more accurate values use iterative methods or financial calculators.

Besides coupon rate vs yield to maturity, current yield is another related term and significantly different from YTM. Current yield focuses on return relative to the bond's market price, not its face value or time till maturity.

Current Yield Formula

Current Yield = (Annual Coupon Payment ÷ Current Market Price) × 100

Unlike YTM, it does not account for capital gain or loss at maturity.

Comparison Table 

This table shows that YTM is the most comprehensive return metric among the three.

Bond prices and yields have an inverse relationship. Here is how:

• If market interest rates rise, existing bonds with lower coupon rates become less attractive. This inverse relationship lowers their market price. This causes YTM to increase. 

• If rates fall, bond prices rise, and YTM falls. 

• Meanwhile, the bond’s coupon rate remains unchanged since it is fixed at issuance.

Both coupon rates vs yield to maturity serve different purposes. They are:

• Coupon rates help evaluate steady income. Ideal for those looking for consistent annual returns

• YTM provides a more realistic return expectation, factoring in bond price and holding period
  

Hence, you should consider both based on whether you value income certainty or total return.

Below is a comparative table outlining key differences in coupon rate vs yield to maturity:

This table simplifies the conceptual differences for clearer understanding.

While useful, both coupon vs yield to maturity come with their specific constraints, listed below. 

Coupon Rate Limitations 

• A bond’s coupon rate  ignores current bond pricing and broader market conditions 

• Coupon income in corporate bonds is taxed as ordinary income 

• When the interest rate increases, bonds with a low coupon rate become less valuable 

• Bonds with high coupon value become more attractive only when interest rates are lower

Yield to Maturity Limitations 

• YTM assumes reinvestment at the same rate, which may not hold true in volatile interest rate environments 

• It does not account for the future price volatility 

• Calculating YTM is quite complex, making it more difficult for you 

Therefore, they should be viewed alongside other indicators and macroeconomic factors.

Understanding the difference between coupon and yield is crucial in evaluating bond investments. While the coupon rate clarifies regular income, YTM offers a complete picture of total expected returns. Each has its value depending on your objectives, whether it be income or long-term growth. Combining both insights can lead to more informed decision-making.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.