Yield to Maturity v. Current Yield v. Coupon Rate
Yield to maturity, current yield, and coupon rate are all terms that describe aspects of bonds and XTBs. Each term is expressed as a percentage, which may be confusing.
For example, an investor might look at a bond with a coupon rate of 7% and think this means the return on the bond is 7%. The coupon rate doesn’t mean this, so the potential for confusion is real. The definitions below should help you to understand what these three terms mean and which measure you should focus on above all others.
Key measures for a corporate bond
The coupon rate is the rate a bond will pay annually, expressed as a percentage of the face value. 5% means $5 per every $100 of face value.
A bond issued today with a coupon rate of 3%, which started trading at $100, would have a coupon rate of 3%. The running yield would also be 3%, and because it is trading at $100, its Yield to Maturity (YTM) would be 3%. But, this is one of the only set of circumstances these three bond parameters would ever have the same value.
As soon as the bond starts trading away from $100, the YTM and the running yield will be different to the coupon rate. The coupon rate remains constant throughout the life of the bond, because it is simply the rate set by the bond Issuer when it was issued.
Tip: You can find the coupon rate of all the underlying bonds available as XTBs via our Available XTBs table. Sort the columns to order the range by highest to lowest.
Yield to Maturity – or just Yield
When you hear people talking about the yield of a bond, they’re usually talking about the Yield to Maturity, or YTM. The YTM of a bond is the ‘total return’ you should receive if you buy the bond today and hold it to maturity. This metric assumes:
- The investor can reinvest all coupons at the same yield; and
- The bond issuer remains viable and does not default.
Yield to Maturity is a measure of returns that should be achieved on the assumptions above, given the known outcomes associated with bonds. If you think about that, how many investments tell you what their return should be? That certainty is one of the key benefits of bonds.
YTM takes into account any capital gain or loss that occurs as a result of receiving the $100 face value back at maturity. Whether investors make a capital gain or loss at maturity is dependent on whether the bond is acquired at a discount or premium to face value.
Because bonds mature, you know you’re getting the $100 face value back, plus known income from coupons along the way. For fixed-rate bonds this gives you predictability of outcomes, with floating rate bonds somewhat less so.
This certainty of returns (subject to no default) is one of the fundamental reasons investors have been investing in bonds for centuries. You can plan your outgoings against known income and capital returns. The YTM or Yield is a very powerful measure of bond returns.
Unlike bonds, shares don’t mature, you have to sell them to get a return and dividends are always variable and at a board’s discretion.
Share returns are driven by two unknown factors:
- Future capital price and
- The income stream.
Current Yield or Running Yield
Current yield is the bond coupon rate expressed as a percentage of the price.
Imagine a 7.75% coupon bond that pays $7.75 per $100 of bondper annum until 2020.
- If that bond was trading at $117.84, its current yield would be 6.58%
- Investors receive $7.75 p.a. for every bond they own.
- From a yearly cash flow perspective investors receive a 6.58% return on the $117.84 they paid for the bond.
When bonds mature, they mature at $100. In this example, the bond will lose $17.84 in price terms by the time it matures. This loss is amortised over the life of the investment. It’s important to not confuse the current yield with the ‘total return’. An investor thinking their total return was going to be 6.58% would be very much mistaken. The capital loss also needs to be taken into account when calculating total returns. YTM does this, so it is the best measure to use.
Telstra 7.75% 2020
This example is the Telstra 7.75% 2020 bond which the XTB on ASX covers. It has a very high coupon rate of 7.75% because it was issued in 2010 when the cash rate was much higher than today. At that time, Telstra needed to pay high coupons to get fund managers to invest for 10 years, when the GFC was still very fresh on people’s minds.
On 14 March 2017, its YTM was 2.54%. The YTM considers the future capital loss of investors receiving $100 face value back on maturity. This rate reflects the markets required yield on a bond issued by an A-rated issuer like Telstra, with the cash rate at 1.5% and TDs ranging from mid 1s to mid 2s.
The current yield simply tells you what the cash flow from coupons each year will be, as a percentage of the bond purchase price. Otherwise, it’s best to ignore current yield as a measure of returns and focus on YTM.
Yield to Maturity – The best measure
If you are happy with the rate based on the YTM on the day you invest, there are no surprises with corporate bonds. That rate is determined when you invest. This allows you to plan your expenses with the knowledge of the exact dates your coupons will be received.
This article was first published in on 14 March 2017.