VR Logo

A bond's coupon is not its yield

Understanding the distinction between the two is important for all fixed income investors

Sometimes the terms 'coupon' and 'yield' are used interchangeably when referring to the payout from a bond. However, the two shouldn't be mixed up. A coupon is the annual interest payment offered by a bond issuer. Yield, on the other hand, is the payout made with reference to the market price of a listed bond.

Coupon and effective yield
If a bond has a coupon of 8% per annum, it means that the annual interest is 8% of the invested amount. This can be paid out monthly, quarterly, annually or cumulatively at the end of the bond tenure. Yield is what a bond earns, expressed as a percentage of its value or market price.

If the interest is paid out annually, then the effective yield on an annual basis is the same as the coupon rate. If the coupon amount is paid out at monthly intervals, that will increase the effective yield in the above example to 8.35%. This happens because it is assumed you will reinvest the coupon amount every month at the rate of 8% per annum.

So don't get cheated into thinking that the real return is higher when bond issues advertise yields instead of their coupon. Similarly, if you invest Rs 1,000 in a bond that offers to double your money in 6 years, then you don't have a coupon. Rather, you get accumulated interest at the end of the tenure and the effective yield of your earnings is 12.25% per annum.

Market yield
This is different from the coupon. Once a bond is listed on an exchange, it carries a market price which is determined by demand and supply. The market yield of a bond is the coupon divided by the market price of the bond and is expressed as a percentage. Bond yield and prices are inversely proportional. A bond is said to be trading at a discount when bond market price is less than the face value and yield is higher than the coupon rate. Bond traders may buy at a premium or discount based on their view of demand or supply and interest rate movements.

Long-term investors who want to buy and hold a bond till maturity, need only be concerned with the coupon on offer and not the yield.