You probably never imagined you’d care about bond coupon vs bond yield, but if you’re thinking of investing in bonds, you should care. When you invest in bonds, there are a few key things you need to know. Your broker should be able to give you that information, including the “CUSIP” number so you can also do some extra research online. (If they don’t have that info, get another broker.)
Even if you trust your broker, take the time to look up the bond to check out the info given. Kind of like a second opinion. The “CUSIP” number will help you look up the bond issue that you’re considering. Check to see what good ole online snooping tells you about those bonds and the issuing company. Also, remember to look for any company financial news.
A bond’s coupon…
… is the interest rate at which the bond is issued. Unlike the yield, this never changes. Let’s look at a bond issued with at a 3% coupon. If you buy it when issued, you will always receive that amount. Usually semi-annually, based on the $1,000 per unit par value of the bond.
Even if the bond price goes drastically up or down, your payment amount will stay the same. Looking at bond coupon vs bond yield, only the yield (see below) will vary. That’s why many retirees like having bonds. They can count on the steady income — based on the coupon rate and how much they originally invested. (The yield is just a current market rate that doesn’t affect their regular payment.)
Of course, if they have to sell the bonds before they mature, then they may not get back what they invested. If rates go up, prices come down, so it depends on the timing of when they invested and where rates are now.
But you get back full face (par) value of the bonds when issued if you can hold them to maturity. That’s a guarantee, as long as the bonds are still solvent. (It pays to buy top quality bonds for that reason.)
A bond’s yield…
…is the percent of return (like an interest rate) that you’ll get from the bond you’re buying. Regardless of the amount yo invest. Looking at bond coupon vs bond yield, the yield reflects current market conditions. Interest rates that have already been factored into the price. So the bond’s yield is, in effect, the extra money you’ll receive regularly as a percent of the exact amount of money you invested.
Note: Bonds can be bought newly-issued or “second hand” from the current owner. The price you pay for an already-issued bond is usually higher [premium] or lower [discount] than the face value or “par”. Bonds are (usually) originally issued in increments of $1,000. But, as is happening now, we see downward pressure on interest rates. This means even some newly-issued bonds can sell at a premium (higher than par value) to accommodate the lower rates. It’s just the way the math works.
A lower “yield to maturity” means that when the bond finally matures, you’ll only get back the original par value. Even if you paid a higher price to buy the bond. Again, it’s about what current market conditions think is a fair price for the type of bond you are buying. The price for older bonds adjust to match what similar newly-issued bonds are yielding. (BOND FACT: as a bond yield goes higher, the bond price goes lower. And vice versa. Again, it’s just the way the math works.)
EXAMPLE OF BOND COUPON VS BOND YIELD CALCULATION
Let’s say you buy 5 units ($1000 per unit) of a 10-year bond that was issued two years ago with a coupon (issue interest rate) of 3%. The current price of the bonds is now $1020 per unit. Since the price is higher, at the very least we know the current yield will be lower. And when we do the calculation for what the yield is at this moment, it comes out to 2.94%.
To summarize bond coupon vs bond yield numbers: You paid $5,100 for 5 units of this bond. Your bond has eight years to go, during which time you will get a 2.94% yield (interest payment) twice a year. When the bond matures, you’ll receive $5,000 in cash. Your total earnings from that bond will be $1200 in interest payments minus the extra premium of $100 that you paid when you bought it.
So your Total Return (net profit) will be $1100 which is actually closer to about a 2.7% effective yield to maturity on your money over the 8 years you owned it. This is true even though the original coupon was 3%. (We’ll save tax implications and actual price paid if you buy the bonds between coupon payments for another day.)
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