Explaining Yields vs Coupon rate of Bonds
When it comes to bond market investing, one thing that confused most of the new and retail investors is the difference between the Bond Yields and Bond Coupon rate. In this article how to differentiate both of them and how each of them helps in understanding the Bond performance and make decisions.
A brief overview of Bonds to those who have very less or confusing idea about Bond Markets.
Bonds are of different types such as Corporate Bonds, Government Bonds and other types of Bonds. Bonds can be categorized as a fixed income instrument that will provide a constant interest rate at regular intervals of time. The company or the government which is issuing the bonds, will while issuing the bonds announcing the Interest rate or most popularly called the coupon rate. The coupon rate will be fixed and will be paid periodically till the maturity period of the bond or till call in the bonds. Maturity is the period at which the company will pay back the principal amount that has been invested in the bond back to the Investors. Hence the investors will get back their principal amount at the end of the maturity period or when the bonds are called in and they will enjoy the interest till that period.
The cost at which each bond will be issued to the Investors is called the face value of the bond. This face value is what will be paid back at the time of the maturity period.
Now Coupon rate as mentioned about is the rate of interest in simple terms that will be paid to the bearer of the bonds at regular intervals of time. The bearer of the Bonds can enjoy this fixed and steady income till the maturity period.
Now after the bonds are issued to the investors, they can also be traded in the secondary market on the stock exchanges. Hence in the secondary market, the price of the bonds will keep changing when they are traded between multiple investors on the stock exchanges.
Now the confusing part is that if the amount of interest that will be received will be constant throughout the period of Bond. And the principle that will be paid back at the maturity period is the same as the face value. Then why did the price of the bond changes constantly on the secondary market?
This is because of several factors that are affecting the broader economy. Understanding this price movement is important to understand what we call Bond Yields.
For example when the interest rates are increasing in the markets, then the interest that is paid by the bond will not be as attractive by the investors as the interest outside the bond markets has increased from the time these bonds are issued, In such cases, the bonds will be not as attractive as they are when the interest rates are low. Hence people will start selling the bonds in order to invest in other high-interest options and hence the price of bonds will drop.
Now even when the price of the bonds start dropping the interest amount that you receive will not be reduced and it will be fixed on the face value of the bond.
For example when issuing the bonds, if they are issued at a face value of ₹10,000 and the coupon rate on the bond is 10% then the interest rate that will be paid is ₹1,000.
But when the Price of the bond fell to ₹9500, then even in such a situation the interest that will be received is still ₹1,000. Hence in such case, the actual returns will be ₹1,000/₹9,500 = 10.52% and this is called the Yield on the Bond.
In such case, the decrease in the price resulted in the increasing of the Yield of the Bond. So an increasing Yield of Bonds is not a indication that the bond is good for investment at present investment.
