Beginning bond investors have a lot to learn, but one of the most important things to understand is the difference between coupon and yield. Coupon tells you what the bond paid when it was issued, but the yield – or “yield to maturity” – tells you how much you will be paid in the future. Here’s how it works:
When a bond is first issued, it has a variety of specific features, such as the size of the issue, the maturity date, and the initial coupon. For example, in 2012 the Treasury may issue a 30-year bond due in 2042 with a “coupon” of 2%. This means that an investors who buys the bond and holds it until face value can expect to receive 2% a year for the life of the bond – or $20 for every $1000 invested.
Once the bond is issued, however, it trades in the open market – meaning that its price will fluctuate throughout each business day for the 30-year life of the bond. Now, fast-forward ten years down the road. In 2022, interest rates have gone up and new Treasury bonds are being issued with yields of 4%. If an investor could choose between a bond yielding 4% and the 2% bond from our example above, they would take the 4% bond every time. As a result, the basic laws of supply and demand cause the price on the bond with the 2% coupon to rise a level where it will attract buyers.
Here’s where math comes into play. Since prices and yields move in opposite directions, a move in the bond’s yield from 2% to 4% means that its price must fall. Keep in mind that the coupon is always 2% - that doesn’t change. As a result, the bond will always pay out that same $20 per year. But for it to yield 4%, its price needs to decline to $500 – or in other words, $20 / $500 = 4%.
So, even in this situation, how does someone earn a 5% yield on a bond with a 2% coupon? Simple: in addition to paying out the $20 each year, the investor will also benefit from the move in the bond price from $500 back to its original $1000 at maturity. Add the annual payment with the $500 principal increase – spread out over 20 years – and the combined effect is a yield of 5%. This yield is known as the yield to maturity.
It works the other way, too. Say prevailing rates fell to 1.5% from 2% over the first ten years of the bond’s life. The bond’s price would need to rise to a level where that $20 annual payment brought the investor a yield of 1.5% - in this case, $1,333.33 (since $20 / $1,333.33 = 1.5%). Again, the 2% coupon falls to a 1.5% yield to maturity due to the decline in the bond’s price from $1333.33 to $1,000 over the final 20 years of the bond’s life.
To gain a better understanding of the relationship between coupon and yield to maturity, take a moment to study this page on the Wall Street Journal’s website, which shows all of the Treasury issues currently trading. As you will see, the high-coupon bonds have yields to maturity in line with the other bonds on the table, but their prices are exceptionally high. A look through this table will help elucidate the relationship between coupon, price, and yield to maturity.
The Bottom Line
When looking at an individual bond, it’s the yield to maturity, and not the coupon, that counts – because it shows what you will actually get paid.
Learn more about bond basics.