There’s often confusion among non professional investors on the meaning of specific fixed income jargon. Terms like coupon, yield, and rates for example are sometimes used interchangeably, though technically, they’re not the same.
The coupon is a cash payment that is promised by a bond issuer, and is intended to be paid to the investor at regular intervals for the entire duration of the bond (with the notable exception of defaults, or situations where the bond issuer cannot honor their payments).
A yield is a measure of the bond’s performance that is obtained by dividing the coupon by the market price of the fixed income instrument – which is 100 at par, but can fluctuate up or down. If a yield increases from the original yield at par – which is equal to the coupon – the price of the bond has decreased.
Rates are usually used as a synonym for the risk-free rate, or the benchmark rate for sovereign bonds. As the risk-free rate increases, the price of the bond decreases and vice versa. Spread refers to the difference between the risk-free rate and the yield of a particular fixed income instrument.
Being able to interpret and use these values can help investors accurately value a fixed income opportunity, better understand market fluctuations, and calculate potential returns of a debt opportunity.
The coupon is the annual payment(s) an investor can expect to receive on a bond, expressed as a percent of the par value, which is also known as the principal. Coupon payments are made at regular intervals, usually a year, though for Treasury notes for example, the interval is six months.
Coupons are “fixed” values – if a bond has a face value of $100 and a coupon of 5%, every year the creditor can expect a $5 payment on the investment, irrespective of factors like bond price (the price at which the bond is being bought and sold in the secondary market) which might be responding to market fluctuations or macroeconomic standards like sovereign interest rates .
But circumstances may, and almost always do change after the bond is issued or purchased. To gain insight on how the coupon rate is holding up in the economic conditions of that point in time, investors can use more dynamic measures like yield and rate.
Current yield is one way to contextualize the coupon value. Unlike a coupon which is static, the yield is a dynamic value that accounts for the current price of the bond.
Take a bond with a face value of $100, which we’ll call XYZ bond. At inception, the bond’s yield is equal to its coupon, because the bond price is at par, or at 100% of the face value. So at issuance it has a 5% coupon and a 5% yield. Over time, several factors may affect the bond price – for example the issuing company performing poorly, or an increase in the risk-free rate – which would drag the bond price below par value. This would then be reflected in the bond quote, which is the percentage of its par value expressed in point scale (a bond trading at 95% of its par value would be quoted at 95).
Now the XYZ bond might be trading at $95, or at a 5% discount to the par value of $100. In this case, the yield also changes because by definition, it takes into account the current price of the bond.
To find the exact value for the yield, the coupon value (=5) is divided by the bond quote (=95). The yield on this bond is then 5.3%.
Bond prices and yields have an intuitively inverse relation – when the price drops, the bond’s yield increases and vice versa. If the XYZ bond is purchased when it’s trading at 95 and held for a year, the investor can expect a return of 5.3%, which is higher than the initial 5% annual yield –- indicating that the bond is trading at a discount to its par value. If it were trading at a premium to the par value (higher than 100), the yield would be lower than the coupon.
While current yield is useful for shorter term investments, creditors depend more on yield to maturity (YTM) for long term bond valuations.
YTM is the percentage rate of return on a bond, assuming it is held until maturity from the time of purchase.
Calculating yield to maturity, also called “book yield” or “redemption yield” is a lot more complicated than calculating current yield, because it accounts for what’s known as the time value of money, a key principle in finance that says that a sum of money is worth more now than it will be in the future. For this reason, YTM is often thought of as the more thorough method of evaluating a debt instrument and has become almost synonymous with “yield” in investing.
YTM value can be derived through trial and error using the formula below or using online calculators.
YTM is especially handy when investors are evaluating a bond’s potential. To judge if a particular bond is a good buy for example, creditors can compare its YTM to the required yield, which is the minimum return that would make an investment worthwhile, as determined by the market.
Moreover, since YTM is expressed as an annual rate regardless of the bond’s term to maturity, investors can also use it when comparing bonds with different maturities and coupons – something that current yield wouldn’t allow, since it doesn’t take maturity into account at all. But similar to current yield, YTM also has an inverse relationship with the bond’s trading level and can help determine whether the bond’s selling at a discount or premium to its par value.
Another dynamic measure that accounts for the debt instruments’ broader economic context is the rate of return. Expressed as a percentage of the investment’s initial cost, the rate of return is the net gain or loss of an investment over a specified time period.
Yield and rate of return can both describe the performance of a bond over a set period but they have subtle differences. Yield is a less precise measure because it’s forward-looking – both current yield and yield to maturity estimate future income from the bond, whether it’s held until the end of the year or to maturity. Meanwhile, rate of return (or more simply, the rate) summarizes the past performance of the bond and determines income earned on the investment so far, while taking into account capital gains, which are assets that gain in value over time.
Spread, risk free rate and Secured Overnight Financing Rate (SOFR) are also key concepts in debt investing and are closely related to yield and rate. They help assess the risk of an issuance or an issuer, as well as the current macro conditions. You can read about them here.
With volatility in rates being a staple of current market conditions, Yieldstreet launched a floating-rate loan offering, supporting the acquisition of a specialized car insurer with strong fundamentals and growth potential. The loan rate is expected to be 7% above the 1-month Secured Overnight Financing Rate (SOFR) – which is currently 1.5% and may increase as the Federal Reserve is tightening rates.
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