Coupon Rates and Current Yield

If you're considering investing in a bond, one of the factors you need to understand is its yield. But it's important to know exactly what type of yield you're looking at.

What exactly is "yield?" The answer depends on how the term is used. In the broadest sense, an investment's yield is the return you get on the money you've invested. However, there are many different ways to calculate yield, particularly with bonds. Considering yield can be a good way to compare investments, as long as you know what yields you're comparing and why.

Coupon rate

People sometimes confuse a bond's yield with its coupon rate (the interest rate that's specified in the bond agreement). A bond's coupon rate represents the amount of interest you earn annually, expressed as a percentage of its face (par) value. If a \$1,000 bond's coupon rate pays \$50 a year in interest, its coupon rate would be 5%.

The coupon rate is typically fixed. Though it does represent what a bond pays, it's not the best measure of the return you're getting on that investment.

Current yield

A bond's current yield represents its annual interest payments as a percentage of the bond's market value, which may be higher or lower than par. As a bond's price goes up and down in response to what's happening in the marketplace, its current yield will vary also. For example, if you bought a \$1,000 bond with a 5% coupon rate for \$900 on the open market, its current yield would be 5.55% (the \$50 annual interest divided by the \$900 purchase price). If you bought the same \$1,000 bond for \$1,200, the current yield would be 4.16% (\$50 divided by \$1,200).

If you buy a bond at par and hold it to maturity, the current yield and the coupon rate would be the same. However, for a bond sold at a premium or a discount to its face value, the yield and the coupon rate are different.

If you are concerned only with the amount of current income a bond can provide each year, then calculating the current yield may give you enough information to decide whether you should purchase that bond. However, if you are interested in a bond's performance as an investment over a period of years, or you want to compare it to another bond or other income-producing investment, the current yield will not give you enough information. In that case, yield to maturity will be more useful.

Watching the Yield Curve

Bond maturities and their yields are related. Typically, bonds with longer maturities pay higher yields. Why? Because the longer a bondholder must wait for the bond's principal to be repaid, the greater the risk compared to an identical bond with a shorter maturity, and the more return investors demand.

If you were to draw a line on a chart that compares the yields of, for example, Treasury securities with various maturities, you would typically see a line that slopes upward as maturities lengthen and yields increase. The greater the difference between the yields on T-bills and 30-year bonds, the steeper that slope. A steep yield curve often occurs because investors want greater compensation for tying up their money for longer periods and running the risk that inflation will cut net returns over time. A flat yield curve means that there is little difference between short and long maturities.

However, sometimes the yield curve can actually become inverted; in this case, short-term interest rates are higher than long-term rates. For example, in 2004 the Federal Reserve Board began increasing short-term rates, but long-term rates didn't rise as quickly. A yield curve that stays inverted for a period of time is believed to indicate a recession may be about to occur.

Yield to Maturity, Yield to Call

Yield to maturity

Yield to maturity (YTM) reflects the rate of return on a bond at any given time (assuming it is held until its maturity date). It takes into account not only the bond's interest rate, principal, time to maturity, and purchase price, but also the value of its interest payments as you receive them over the life of the bond. Yield to maturity includes the additional interest you could earn by reinvesting all of the bond's interest payments at the yield it was earning when you bought it.

If you buy a bond at a discount to its face value, its yield to maturity will be higher than its current yield. Why? Because in addition to receiving interest, you would be able to redeem the bond for more than you paid for it. The reverse is true if you buy a bond at a premium (more than its face value). Its value at maturity would be less than you paid for it, which would affect your yield.

Example: If you paid \$960 for a \$1,000 bond and held it to maturity, you would receive the full \$1,000 principal. The \$40 difference between the purchase price and the face value is profit, and is included in the calculation of the bond's yield to maturity. Conversely, if you bought the bond at a \$40 premium, meaning you paid \$1,040 for it, that premium would reduce the bond's yield because the bond would be redeemed for \$40 less than the purchase price.

Why is yield to maturity important?

Yield to maturity lets you accurately compare bonds with different maturities and coupon rates. It's particularly helpful when you are comparing older bonds being sold in the secondary market that are priced at a discount or at a premium rather than face value. It's also especially important when looking at a zero-coupon bond, which typically sells at a deep discount to its face value but makes no periodic interest payments. Because you receive all of a zero's return at maturity, when its principal is repaid, any yield quoted for a zero-coupon bond is always a yield to maturity.

Yield to call

When it comes to helping you estimate your return on a callable bond (one whose issuer can choose to repay the principal before maturity), yield to maturity has a flaw. If the bond is called, the interest payments will come to an end. That reduces its overall yield to the investor. Therefore, for a callable bond, you also need to know what the yield would be if the bond were called at the earliest date allowed by the bond agreement. That figure is known as its yield to call; the calculation is the same as with yield to maturity, except that the first call date is substituted for the maturity date.

A bond issuer will generally call a bond only if it's profitable for the issuer to do so. For example, if interest rates fall below a bond's coupon rate, the issuer is likely to recall the bond and borrow money at the newer, lower rate, much as you might refinance your mortgage if interest rates drop. The less time until the first date the bond can be called, and the lower that current interest rates are when compared to the coupon rate, the more important the yield-to-call figure becomes.

Why is yield to call important?

If you rely on the income from a callable bond--for example, if it helps pay living expenses--yield to call is especially significant. If the bond is called at a time when interest rates are lower than when you purchased it, that reinvested principal might not provide the same amount of ongoing income. Why? Because you would likely have difficulty getting the same return when you reinvest unless you took on more risk.

Comparing Taxable and Tax-Free Yields

\$5,000 taxable bond paying 5% interest \$5,000 municipal paying 3.5% Federal tax bracket 28% 33% 35% 39.6% Annual interest \$250 \$250 \$250 \$250 \$175 Paid in taxes \$70 \$82.50 \$87.50 \$99 \$0 Net income \$180 \$167.50 \$162.50 \$151 \$175

 \$5,000 taxable bond paying 5% interest \$5,000 municipal paying 3.5% Federal tax bracket 28% 33% 35% 39% Annual interest \$250 \$250 \$250 \$250 \$175 Paid in taxes \$70 \$82.50 \$87.50 \$99 \$0 Net income \$180 \$167.50 \$162.50 \$151 \$175

Note: This hypothetical example is intended only as an illustration and does not reflect the return of any specific portfolio.

It's important to consider a bond's after-tax yield--the rate of return earned after taking into account taxes (if any) on income received from the bond. Some bonds--for example, municipal bonds ("munis") and U.S. Treasury bonds--may be tax exempt at the federal and/or the state level. However, most bonds are taxable.

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