Yield Versus Coupon
The yield-to-maturity is possibly one of the most critical figures to look at when assessing a bond for investment, since that represents a fairly good approximation of the rate of return that an investor could receive from holding a bond to maturity. However, investors may be confused given that bonds also have coupons, which are a known quantity for each bond issue. So what’s the difference between yield and coupon?
While the two figures are related, it is perhaps important to highlight the key differences between the two. Coupons represent the fixed amount of interest to be paid out for each bond (expressed as a percentage of the bond’s face value, say $5 per year on par value of $100, a 5% p.a. coupon rate). However, bond prices can change as investors demand higher or lower yields on the bond in the secondary market, so even as the coupon rate is used to derive the bond’s yield, changes in bond prices will mean that the yield that an investor receives could be higher or lower than the coupon rate. As a rule of thumb, if an investor buys a bond above par value (eg. $105 versus $100 face value), the actual yield on the bond will be lower than the coupon rate. Conversely, if an investor buys a bond at a discount to par value (eg. $95 versus $100 face value), the yield on the bond to the investor would be higher than the stated coupon rate. It is thus not difficult to see that the only time a coupon rate equals the bond’s yield is when the investor purchases the bond at par value (eg. paying $100 for $100 of face value). As such, investors seeking out bonds to invest in may wish to focus more on the bond’s yield-to-maturity rather than paying too much attention to the bond’s coupon rate.
Maturity And The Yield Curve
When investing in bonds, there are certain trade-offs involved between credit risk and a bond’s yield. For example, an investor seeking out a higher yield on a bond investment may have to look for bonds of companies which are perceived to be financially weaker, smaller in size, or have businesses which are less stable compared to their “blue chip” peers. In addition to the trade-off between credit and yield, investors will find that there is also a relationship between maturity and yield.
Chart 1 shows the US Treasury yield curve, which is a visual representation of the different Treasury yields associated with different bond maturities. In most cases, the yield curve is upward-sloping (as is the case in Chart 1), indicating that the longer the maturity of the bond, the higher the bond’s yield. Why is this so?
An investment in any bond is subject to interest rate risk – the risk that a bond’s price could decline if interest rates rise. As compared to shorter maturity bonds, bonds with a longer time to maturity are more susceptible to price declines when interest rates rise, which means investors in longer-dated bonds require additional compensation for taking on this addistional interest rate risk (in the form of higher bond yields, which leads to an upward-sloping yield curve). Of course, an investor holding a bond to maturity (and who ignores mark-to-market price fluctuations) would not worry too much about interest rate risk, as long as the bond’s time to maturity matches the investor’s investment horizon. Both yield-to-maturity as well as a bond’s time-to-maturity are critical factors for investors picking a suitable bond for investment.
Chart 1: The US Treasury Yield Curve
The Research Team is part of iFAST Financial Pte Ltd.