Yield to maturity, current yield and coupon rate explained

Each of these terms that describe aspects of bonds is expressed as a percentage, so it can get confusing for investors who don’t understand what each means. An investor might look at a bond with a coupon rate of 5% and think this means the return on the bond is 5%, however this is not the case.

We explain each of the terms and help investors understand which measure they should focus on above all others.

Table 1: A corporate bond has various measures

Example of Dexus 2027 XTB on 30 May 2019 (source Bloomberg and ACBC)

The Coupon Rate

This is the rate (of interest) a bond will pay bondholders annually. It is expressed as a percentage of the face value, so a 5% coupon means investors receive $5 per annum for each $100 of face value they hold of that bond.

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: Use the Available XTBs table to see the coupon rates of the underlying bonds available as XTBs. Sort the columns to order the range highest to lowest.

The Face Value

All bonds have a face value determined at issue, for all XTBs this is $100. This means for each XTB unit held, investors will receive $100 at maturity (assuming no default).

Current Price

The amount investors pay for a particular bond today. In the past, bonds have been hard to access due to high investment amounts and the lack of availability on ASX. But the range of approximately 50 XTBs now provides daily transparent pricing for investors to trade on ASX. And, the ability to buy single XTB units with a $100 face value has removed the high barrier of investment.

The Yield to Maturity (or total return)

When people talk about the yield of a bond, they’re generally talking about the Yield to Maturity, or YTM. This measures the ‘total return’ investors should receive if they buy the bond today and hold it to maturity. YTM assumes:

1. The investor can reinvest all coupons at the same yield; and
2. The bond issuer remains viable and does not default.

It takes into account all of the coupon payments received from the date of purchase until the date of maturity. Importantly, it also accounts for any capital gain, or loss, due to the $100 face value received 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. (link to why bond a bond at a premium article)

The power of predictability

We’ve seen that the YTM for a bond should be achieved on the assumptions above. Very few investments can tell you, before you invest, what their return should be. It’s that predictability which is one of the key benefits of bonds. It’s something that cannot be offered by shares, and perhaps surprisingly it cannot be offered by Bond ETFs either.

Because bonds mature, investors know they will receive the $100 face value at maturity (subject to no default). They also know whilst they hold that bond investment they will receive a known income from coupons. They also know the set dates they’ll receive this income. For fixed-rate bonds this gives investors considerable predictability of outcome.

It’s this predictability of returns which is one of the fundamental reasons investors have been investing in bonds for centuries. Bonds allow investors to plan their outgoings against known income and capital returns. YTM is a very accurate measure of bond returns.

Shares and surprisingly even bond ETFs can’t offer this

Shares don’t mature. Investors 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
• Income stream.

It is the same with all bond ETFs and managed funds. They are perpetual – they don’t have an end date and therefore they can’t provide a predictable return BEFORE you invest.

Also, being pooled products, new bonds are added or removed, sometimes on a daily basis, with potentially hundreds of bonds included. That’s good for diversification, but it means you don’t know what your income or return will be.

Knowing your cash flow BEFORE you invest is at the heart of fixed income.

Tip: The XTB Cash Flow Tool and Yield Calculator help determine the return from XTBs.

The Current Yield or Running Yield

Possibly the most confusing of the terms is current or running yield which is the bond coupon rate expressed as a percentage of the price. Importantly, it does not factor in the $100 face value received at maturity.

Example:

A bond with a coupon of 7.75% pays $7.75 per $100 of bond p.a. until it matures in 2022.

If that bond was trading at $117.11, its current yield would be 6.61% ($7.75/$117.11).

Investors would receive $7.75 p.a. for every bond they own, so from a yearly cash flow perspective they receive a 6.61% return on the $117.11 they paid for the bond.

But,

This measure does not factor in the maturity value of $100. By the time the bond matures in 2022 it will have lost $17.11 in price terms. This loss is amortised over the life of the investment.

So, it’s very important to not confuse current yield with ‘YTM’ – an investor thinking their total return was going to be 6.61% would be sadly mistaken.

Let’s look again at our example in Table 1

This Dexus bond has a coupon rate of 4.25% and on 31 May 2019, had a current yield of 3.79% and a yield to maturity of 2.62%.

Remember, it’s only the YTM which considers the future capital loss of receiving only the $100 face value back on maturity. This total return reflects the yield on a bond issued by an investment grade issuer such as Dexus, at a time when the cash rate is so low and Term Deposits are struggling to reach much beyond the low 2’s. (Source: Canstar).

The current yield simply tells you what the cash flow from coupons each year will be, as a percentage of the bond purchase price.

Yield to Maturity: The measure to focus on

We’ve covered some of the key measures associated with bonds and determined that for fixed rate bonds YTM is the measure to focus on. When considering a bond, or an XTB, if you are happy with the return based on the yield to maturity on that day, then that should be the return you receive. As we’ve also seen by sticking with investment grade issuers, the likelihood of default is also considerable reduced.

The predictability of bonds gives the freedom to plan expenses with the knowledge of when you will receive coupon payments and when you will receive the bond face value. Keeping your fixed income predictable can provide greater peace of mind as it restricts the uncertainty in an investment portfolio to growth assets.

Disclaimer

The information in this article is general in nature. It should not be the sole source of information. It does not take into account the investment objectives or circumstances of any particular investor. You should read the PDS that relates to that Class of XTB prior to making an investment decision and consider, with or without advice from a professional adviser, whether an investment is appropriate to your circumstances. Australian Corporate Bond Company Limited is the Securities Manager of XTBs and will earn fees in connection with an investment in XTBs.