When you’re just starting your investment journey, you’ll receive advice telling you to diversify your portfolio and consider the risks before purchasing a bond. The last thing you want is to lose money.
On top of understanding the strategies it takes to make a profit off your investments, there are terms you’ll also need to know, including yield to maturity vs coupon rate. These two phrases will help you determine your bond earnings, but they aren’t synonymous.
Here’s a breakdown with everything you need to know about yield to maturity vs. coupon rate:
What Is the Coupon Rate?
A bond’s coupon rate is the fixed percentage of interest you will earn on an annual or semi-annual basis once you purchase it up until the maturity date (the date the bond issuer agrees to repay its investor by when it is purchased). For example, if you take out a $1,000 bond with a coupon rate of 4% and it has an annual payment system, you’ll earn $40 every year until it matures.
One of the benefits of purchasing a bond over stock is that the interest rate won’t fluctuate even if the market does. The key to making more than the price you’ve paid for the bond is to purchase it at a discount.
A discount bond means that the value is worth more than the price you’ve paid for it. Alternatively, there are premium bonds where the price is worth more than the value. If the price and the value are the same, you are purchasing it at face value.
However, some investors want to take risks and earn more interest from their bonds. This finance business offers high yield investments with interest rates as high as 10%. You can sell the bond before the maturity date if need be, allowing you to take out the interest you’ve accumulated up until that point.
What Is the Yield to Maturity (YTM)?
While the coupon rate determines annual interest earnings, the yield to maturity determines how much you’ll make back in interest throughout the bond’s lifespan. The YTM considers market changes because, even though your bond’s interest rate will not change, its value will fluctuate depending on the market’s rates.
You need to know the coupon rate, the price of the bond, its value, and the maturity date to calculate the YTM. If you purchase the bond at face value, the YTM and the coupon rate are the same. Otherwise, the YTM increases or decreases depending on whether you’ve purchased a discount or premium bond.
Compare the Yield to Maturity vs Coupon Rate Before Purchasing Bond
Investing your money is not an action you should take lightly. When it comes to purchasing bonds, you want to make sure you’ve got a solid understanding of where it’s going and what will happen to it over time.
Now that you understand the difference between yield to maturity vs coupon rate, you know to calculate them before buying a bond.
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