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.
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.
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.