What are Bonds, coupons and yield to maturity?

(This post explicates the difference between coupon rate and yield to maturity)

Bonds: A bond is a debt instrument issued by a company or the Government to raise capital by way of borrowing from the investors. The investors in the bonds are debt holders (lenders/creditors). The issuer of bonds is obliged to pay bondholders the interest (the coupon) at the pre-decided rate and to repay the principal on a due date termed the maturity date. Like Bank deposit receipts issued by banks, the issuer of bonds also gives standardized certificates (nowadays, most bond certificates are in electronic forms) to the bondholders. Because bonds are debt securities, they can be easily bought or sold to other investors in the financial market.

Bonds can be traded at a discount, at par, or at a premium. When the bond is priced at par, the interest rate is equal to its coupon rate. A bond priced above par is called a premium bond. A premium bond has a coupon rate higher than the interest rate. The bond priced below par is called a discount bond, which has a coupon rate lower than the interest rate.

Learn more about different kinds of bonds

Read:

1. WHAT IS A ZERO-COUPON BOND?

2. WHAT ARE FOREIGN BONDS, EURO BONDS, AND GLOBAL BONDS?

3. WHAT IS INFLATION INDEXED BONDS OR IIB?

4. WHAT IS YIELD OR YIELD TO MATURITY (YTM) OF BONDS?

5. CONVERTIBLE BONDS, FLOATING RATE BONDS AND NEGATIVE BONDS

6. DO YOU KNOW THE MEANING OF MASALA BONDS?

Coupon: Coupon rate (or simply a coupon) is the periodic rate of interest to be paid by the bond issuer to the bondholders. The coupon rate is calculated on the bond’s face value (or par value) not on the issue price or market value of the bond. For example, if you have a 12-year, Rs.5000 bond with a coupon rate of 8 percent, you will get Rs.400 every year for 12 years, irrespective of the changed price of that bond in the market.

Yield to Maturity (YTM):  The term ‘yield to maturity’ is used to indicate the returns an investor gets on his investments by reinvesting every periodic coupon payment from the bond at a fixed interest rate until the bond’s maturity date. The ‘yield to maturity’ to an investor who bought the bonds at market price will be usually different from one who bought it originally at the issue price. For example, if interest rates were currently gone up to 6% then the bonds with a coupon rate of 5% would be traded at a discount rate in the market. Since the coupon rate is calculated on the bond’s face value (or par value),  not on the market value, YTM for the purchaser of such bonds from the market is higher than its coupon rate. Let’s take an example, that you have bought a bond for Rs.900 with a face value of Rs.1000 and it has a coupon rate of 10%. Let us say that there is exactly one year left on this bond. Now you will receive Rs.100 interest for Rs.900 for one year. Therefore, the yield on the bond is 100/900*100=11.11%. In this case, the yield is higher than the coupon rate. Conversely, a bond purchased at a premium always has a yield to maturity that is lower than its coupon rate.

Conclusion: We may conclude that a bond’s coupon rate is the actual amount of periodic interest income earned on a bond.  Whereas, a bond’s yield to maturity (YTM) is the estimated rate of return, assuming that it will be held until its maturity date and not called.

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