The Difference Between Coupon and Yield to Maturity

Beginning bond investors have a significant learning curve, but take heart. There's a lot to learn,
but the difference between coupon and yield is a good place to start. It's onward and upward after
you master this.

Coupon tells you what the bond paid when it was issued, but the yield – or “yield to maturity” –
tells you how much you will be paid in the future. Here’s how it works.

Coupon Vs. Yield to Maturity

A bond has a variety of specific features when it's first issued, such as the size of the issue, the
maturity date and the initial coupon.

For example, the Treasury may issue a 30-year bond in 2017 that's due in 2047 with a “coupon”
of 2 percent. This means that an investor who buys the bond and who owns it until face value can
expect to receive 2 percent a year for the life of the bond, or $20 for every $1000 invested.

The bond trades in the open market, however, after it's issued. This means that its price will
fluctuate over the course of each business day throughout the 30-year life of the bond. Now fast-
forward ten years down the road. Interest rates have gone up in 2027 and new treasury bonds are
being issued with yields of 4 percent.

If an investor could choose between a bond yielding 4 percent and the 2-percent bond, he would

take the 4-percent bond every time. As a result, the basic laws of supply and demand cause the
price of the bond with the 2-percent coupon to rise to a level where it will attract buyers.

Do the Math

Here’s where math comes into play.

Prices and yields move in opposite directions, so a move in the bond’s yield from 2 percent to 4
percent means that its price must fall. Keep in mind that the coupon is always 2 percent – that
doesn’t change. The bond will always pay out that same $20 per year. But its price needs to
decline to $500 – or in other words, $20 divided by $500 or 4 percent – for it to yield 4 percent.

So how does someone earn a 5 percent yield on a bond with a 2 percent coupon even in this
situation? Simple: In addition to paying out the $20 each year, the investor will also benefit from
the move in the bond price from $500 back to its original $1000 at maturity. Add the annual
payment with the $500 principal increase – spread out over 20 years – and the combined effect is
a yield of 5 percent. This yield is known as the yield to maturity.
It works the other way, too. Say prevailing rates fell from 2 percent to 1.5 percent over the first
10 years of the bond’s life. The bond’s price would need to rise to a level where that $20 annual
payment brought the investor a yield of 1.5 percent – in this case, $1,333.33 because $20 divided
by $1,333.33 equals 1.5 percent. Again, the 2-percent coupon falls to a 1.5-percent yield to
maturity due to the decline in the bond’s price from $1333.33 to $1,000 over the final 20 years of
the bond’s life.