A coupon is the rate of interest that is paid on a bond by the bond issuer to the bondholder.
A coupon is expressed as a percentage of the bond's face value, which is the amount that the bondholder will receive when the bond matures.
For example, a bond with a face value of Rs. 1,000 and a coupon rate of 7% would pay the bondholder an annual interest of Rs. 70.
The government sets the minimum interest rate that bond issuers can pay. This is done to ensure that investors receive a fair return on their investment.
If the government increases the minimum interest rate, then all bond transactions that are precursory to this development and have coupon rates below the new minimum will stand to lose their worth. This is because investors will be able to get a higher interest rate on newly issued bonds.
The market price of a bond is determined by the rate of interest that investors can earn on similar investments. Therefore, to compensate investors for the lower coupon payments, bondholders who want to sell their old bonds must lower their asking price.
A bond purchased for more than its face value is said to be trading at a premium. On the other hand. a bond that is purchased for less than its face value is said to be trading at a discount.
The coupon payments are the same too, irrespective of the purchase price.
Yield refers to the total return that an investor can expect to receive from a bond, including both the coupon payments and the capital gain or loss that the investor will realize when the bond matures.
Let us focus on current yield, which is a useful measure for comparing bonds with different prices and coupon rates. There are various kinds of yield, such as:
Yield to maturity
Yield to call
Yield to worst
Bond equivalent yield
Annual percentage yield
Effective annual yield.
Yield is closely connected to bonds; it relates to the return on the amount one invests in a bond. For example, a Rs. 1,000 bond with a 6% coupon rate that sells for Rs. 1,000 has a current yield of 6%. However, if the same bond sells for Rs. 800, its current yield will be 7.5%. This is because the Rs. 60 annual coupon payments represent a larger share of the purchase price when the bond is bought at a discount.
However, it is important to note that it does not take into account the time value of money. This means that a bond with a higher current yield may not necessarily be a better investment, even if it has a longer maturity date.
What is the Difference Between Coupons and Yield?
In the context of bonds, 'yield' and 'coupon' are two different terms, but both refer to the return on investment of a bond.
A coupon is the rate of interest that a bond issuer delivers to bondholders. It's typically expressed as a percentage of the bond's face value, which is the amount that the bondholder will receive when the bond matures.
Yield is the return that an investor can receive from a bond. Yield includes coupon payments and the capital gain or loss when the bond matures.
There are various ways to calculate the yield on a bond, but the most common method is to divide the bond's annual coupon payment by its current market price.
It is important to note that yield and coupon are not the same thing.
A bond's yield can change over time, even if the bond's coupon rate remains the same. This is because the bond's market price can fluctuate. For example, if interest rates rise, the market price of a bond with a fixed coupon rate will fall. This will cause the bond yield to increase. Conversely, if interest rates fall, the market price of a bond with a fixed coupon rate will rise. This will cause the bond yield to decrease.
It's important to consider both the coupon rate and the yield, as they provide information about the amount of income and return you can anticipate from a bond, respectively.