Bond Yields Explained: Understanding Coupon Rate, Current Yield, and YTM

Over the years, India’s bond market has witnessed significant growth, providing more opportunities to diversify portfolios beyond fixed deposits and equities. Bonds are considered one of the safest types of investment and are widely used by risk-averse investors, pensioners, and institutions. As opposed to stocks that provide profits through dividends and capital gains, bonds pay interest regularly.

The bond market in India deals with various investment vehicles such as Government Securities (G-Secs), State Development Loans (SDLs), Treasury Bills (T-Bills), and corporate bonds. Despite the growing investment landscape in the bond market, many investors are confused about terms such as “coupon rate”, “current yield”, and “yield to maturity (YTM)”.

Although the terms 'coupon rate,' 'current yield,' and 'yield to maturity' are used interchangeably, these are actually various methods of evaluating a bond yield.

Let us understand this with an example: There is a government bond with a coupon rate of 7.10% with a YTM of 7.35% as it is trading at a discount. In the same manner, a bond with the same coupon rate will have a smaller YTM as it is trading at a premium.

What is a Bond?

A bond is simply a loan given out by the investor to a borrower, such as a government, municipal body, or corporate organisation.

In buying a bond,

• You are simply lending money to the borrower.
• The borrower pays you interest in installments (coupons).
• The borrower pays back your principal at maturity.

Indian bonds are issued by many issuers, such as:

• Government of India (G-Secs)
• State Governments (SDLs)
• Public Sector Undertakings (PSUs)
• Commercial banks and other financial institutions
• Private Corporations - Corporate Bonds

For instance, you buy a government security, where:

• Face Value = ₹1,000
• Coupon Rate = 7%
• Maturity = 10 years

Then, you will receive ₹70 each year as interest and your ₹1,000 at the time of maturity of the bond.

What is Bond Yield?

Bond yield refers to the returns earned by investors from a bond. Bond yields are represented as a percentage indicating income or total returns that a bond provides. While the coupon rate remains constant throughout the bond’s tenure, bond yields may vary depending on changes in bond prices.

When bond prices fall, bond yields will rise because investors can receive the same coupon payments with a smaller investment amount. On the other hand, when bond prices rise, bond yields fall because investors have to invest a greater amount of money to receive the same fixed interest payments.

The three most commonly used measures of bond yield are:

• Coupon Rate: How much does the bond earn in terms of interest?
• Current Yield: How much income is earned by the bond considering the current market price?
• Yield to Maturity: How much return does the bond provide annually over its lifetime?

Understanding these terms allows investors to make better comparisons among different bonds.

What is Coupon Rate?

The coupon rate is the yearly interest promised by the issuer of a bond as a percentage of the bond’s face value. It is important to note that a bond’s coupon rate remains fixed once the bond is issued.

Coupon Rate = (Annual Interest Payment/Face Value) x 100

Let us consider that the Government of India issues a bond whose features are:

• Face Value = ₹1,000
• Interest per Year = ₹72

Coupon Rate = (72 ÷ 1,000) × 100 = 7.2%

This means that the investor holding this bond will receive ₹72 as interest each year.

Features of Coupon Rate

The coupon rate has certain characteristics that include the following:

• It is fixed when the bond is first issued.
• It is determined based on the face value of the bond and not the market value.
• It shows the interest income payable to the bondholder at regular intervals.
• It cannot determine the return on the bond if bought in the secondary market.

What is Current Yield?

Current yield is the annual rate of interest income on the bond based on its market price instead of its face value. As opposed to the coupon rate, the current yield will vary according to the change in the price of the bond.

Current Yield = (Annual Coupon Payment/Current Market Price) x 100

Let us understand the current yield with this example:

Assume that there is a government security (G-Secs):

• Face Value of the Bond = ₹1,000
• Coupon Rate = 7%
• Coupon Amount = ₹70
• Market Value of the Bond = ₹950

Current Yield = (70 ÷ 950) × 100 = 7.37%

Even though the coupon rate is just 7%, the investor’s current yield is more than the coupon rate due to the purchase of the bond at a lower price than its nominal value.

Features of Current Yield

• The current yield is a measure of the return that a bond provides annually as a function of its current price.
• The current yield changes with fluctuations in the bond's market price.
• Any reduction in the market price of a bond results in an increase in the current yield, while an increase in price leads to a decrease in the yield.
• It enables the comparison of returns from various bonds.

Also Read: Why Bond Yields Rise When Bond Prices Fall: A Simple Guide

What is Yield to Maturity (YTM)?

The coupon rate indicates the amount of interest that a bond will pay, while the current yield indicates the income that an investor makes from a bond depending on its market value. However, neither the coupon rate nor the current yield gives a full view of a bond’s returns. This is where Yield to Maturity (YTM) comes in.

Yield to maturity is the total annualised return on investment that will accrue to an investor who purchases a bond at its prevailing market price and holds it to maturity, assuming the following :

• Coupon payments will be made on time.
• Coupon payments will be reinvested at the same interest rate.
• There is no default by the bond issuer.
• The bond is held till maturity.

Unlike coupon rate and current yield, YTM considers the following:

• Annual coupon payments
• Current market price
• Par value
• Time to maturity
• Capital gain or capital loss on maturity
• Time value of money

Yield to maturity is considered to be the most comprehensive measure of return on bond investments.

Why is Yield to Maturity Important?

Consider two G-Sec that are being compared; both have a coupon rate of 7%.

Both bonds will earn ₹70 per year as they have the same face value of ₹1,000.

But:

• Bond A is bought at a discount, and therefore the investor earns ₹50 at maturity due to the face value of ₹1,000.
• Bond B is bought at a premium, and hence the investor loses ₹50 at maturity.

Though the coupon amount is the same, the total amount earned by the investor varies. The YTM includes both interest earnings and capital gains or losses.

Coupon Rate vs Current Yield vs Yield to Maturity

Which Yield Investors Should Consider?

The answer depends on what you are looking for, as each measure gives different results.

• Coupon Rate: It can be used to approximate the annual interest that is paid.
• Current Yield: It helps compare income generated at the present price level.
• Yield to Maturity (YTM): It can be considered as the complete measure since it includes coupon payments, the purchase price, redemption value, and the time value of money. In case one wants to keep a bond until its maturity, YTM is usually the most suitable measure of comparison.

Factors Affecting Bond Yields in India

Various factors influence bond yields in the Indian debt market.

RBI Monetary Policy: The Monetary Policy Committee (MPC) of the RBI determines the repo rate, which influences the interest on loans.

• If the repo rate is high, it tends to raise the bond yield.
• If the repo rate is low, it leads to a fall in the bond yield.

Inflation: Inflation decreases the purchasing power of future interest payments. In case of expectations of inflation, investors require high yields as compensation. However, low inflation supports the fall in bond yields.

Credit Risk: Bonds are one of the safest fixed-income securities in India, as they are issued and guaranteed by the Government of India. The credit risk of corporate bonds depends on the creditworthiness of the issuing corporation. Issuers that have low credit ratings always have to pay a high yield to attract buyers.

Time to Maturity: Long-term bonds generally offer higher yields than short-term bonds since investors are compensated with more return for investing for a longer period of time. This difference in yields across bonds with varying maturities is reflected in the shape of the yield curve.

Market Demand: Banks, insurance firms, mutual funds, and pension funds are among the largest institutional investors that are involved in India’s bond market. An increase in demand for government securities leads to higher prices and lower yields of these securities. On the other hand, a reduction in demand leads to lower prices and higher yields of government securities.

Common Mistakes to Avoid While Measuring Bond Yield

• Thinking that a high coupon rate means a better deal. Even if the bond offers a low coupon yet is being sold at a discount, its YTM might be much higher.
• Ignoring YTM. By paying attention solely to the coupon payments, one fails to compare the investments properly.
• No attention is given to interest rate risk. An increase in interest rates decreases the value of existing bonds in the market.
• The coupon rate should not be confused with the return on investment because the coupon rate does not consider the purchase price of the bond.