Wednesday, March 28, 2018

Bond Coupon Rate and Yields

After starting this blog back in 2016, I realised that I have yet to write a single post on bonds. Let me start the bond ball rolling by explaining bond coupon rate and the two common bond yields used, current yield and yield to maturity.

Coupon Rate and Current Yield

The coupon rate of a bond is always calculated based on its par value. If a $1,000.00 bond’s annual coupon rate is 5%, the bondholder will get $50.00 per year (5% of $1,000.00 = $50.00).

Like any investments, the market value of a bond will fluctuate depending on its demand and supply. Since the coupon rate is fixed, we could use current yield calculations to see if it is higher or lower than the coupon rate.

If the market price of the bond is $950.00, the current yield would be $50.00/$950.00 x 100% = 5.26%.

If the market price of the bond is $1,050.00, the current yield would be $50.00/$1,050.00 = 4.76%.

From the calculations, it is observed that if the bond is at a premium (above the par value), the yield would be lower than the coupon rate, and vice versa if the bond is at a discount (below the par value).

Yield to Maturity

Another way to look at bond yields would be the yield to maturity (YTM). According to Investopedia, YTM is “the total return anticipated on a bond if the bond is held until it matures”1, and some bond investors prefer to look at YTM as it could be used to compare with other bonds that have different coupon rates and tenures.

Calculating YTM is a bit more difficult than calculating current yield as the former involves present value calculations, but the good news is there are online calculators available.

Providing some examples, if a $1,000.00 bond with a 5% coupon rate (paid annually) and 10-year tenure is priced at $950.00 in the financial markets, the YTM would be 5.67%. If the same bond is priced at $1,050.00 instead, the YTM is 4.37%.

Relationship Between Coupon Rate, Current Yield and YTM

From the above example calculations, we can clearly see the relationship between the coupon rate, current yield and YTM. Below shows the relationship summary conveniently.

Bond priced at par: coupon rate = current yield = YTM
Bond priced at premium: coupon rate > current yield > YTM
Bond priced at discount: coupon rate < current yield < YTM

1 – Investopedia. Yield to Maturity. (accessed 27 Mar 2018).

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