With interest rates moving higher over the last 18 months, many investors are concerned that they are not earning anywhere near market rate on their bonds. They’re holding bonds at 3.25% while new bonds are yielding around 4.60%. In some but not all cases, the issue is that the coupon on the bond is being confused for the yield to maturity.
A bond’s coupon rate represents the yearly interest paid by the bond with respect to its face value. Say the U.S. government issues a bond with a face value of $100,000. The interest rate on this bond is set at 3.25% per year, called the coupon rate. An investor holding this bond will receive $3,250 per year as interest payments. It does not matter if the investor paid par value ($100,000) for the bond or bought it at a discount to par value. Let’s say they paid $91,480; the coupon is still 3.25% of face value, and the investor still receives the $100,000 face value at maturity.
The major difference between a bond’s coupon rate and yield to maturity is that the coupon rate is, in most cases, fixed throughout the tenure of the bond. However, in the case of the yield to maturity, it changes depending on several factors, like the time until maturity and the current price of the bond.
The yield to maturity represents the return rate an investor realizes by holding the bond until maturity. The yield to maturity becomes relevant when an investor purchases the bond from the secondary market at a price not equal to par value. Take our investor who has a bond with a face value of $100,000 and a coupon rate of 3.25%. Assume he purchased the bond at a price of $91,480 on the secondary market. Not only will the investor receive the stated coupon of 3.25% or $3,250 per year, but the bond will mature at a price greater than what the investor paid for it, adding an additional component of return, the price appreciation, thus making the yield to maturity 4.99%. Paying below par can make a meaningful difference in the yield to maturity and should be considered rather than simply looking at a bond’s coupon.
For those who purchased bonds several years ago and still hold them today, it may be enticing to think you can get a better yield by selling the bonds you hold and buying those with a similar maturity but a higher coupon yield. Unfortunately, your bonds have likely declined in price, and you would realize a loss in selling them. Is it possible to achieve a higher return by extending the maturity date? It depends on current yields, what you paid for it, and the maturity date. It’s not as simple as trading a 3.25% yield for a 4.60% yield. You must focus on the yield to maturity.
We generally recommend purchasing bonds to protect the principal of your investment—not chase higher yields. Ideally, the money you hold in bonds is to fulfill a spending need upon maturity. If you need the principal in 2030, you would not likely be able to buy an equivalent amount in the higher yielding bonds relative to those you already hold for that spending need. You’ll likely end up in the same place where you started, as in many cases, bonds of similar credit quality and maturity trade at a similar yield, especially in the Treasury market as it is a very efficient market.
If you have questions on your fixed-income investments, the experts at Henssler Financial will be glad to help:
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