The myth
When it comes to bonds, the coupon rate (the rate of interest that it pays, expressed on a yearly basis) is the first thing that is usually considered. It makes it easy for you to understand how much you could earn by investing in the bond.
That’s why many people believe that the bond yield is always the same as the coupon rate.
Why do people believe it?
A lot of the time, the bond yield may actually be equal to the coupon rate, especially during the issuance or offer period when they are sold at face value.
For example, if you buy a P100,000 bond with an annual coupon rate of 5% and a 5-year maturity at its face value, you will be earning P5,000 each year for 5 years for a total of P25,000 over the bond’s life, and then get back the P100,000 principal back at the end.
If you bought the bond at face value, the coupon rate and the bond yield are the same at 5%.
Risks of believing this myth
While the coupon rate is always fixed, bond yields, or an investor’s actual return, may vary. This is because bonds have their own respective prices and can be sold to other investors at a premium or at a discount.
If the bond is selling at a discount (when the price is lower than face value), then the yield will be higher than the coupon rate. However, if the bond is selling at a premium (when the price is higher than face value), then the yield will be lower than the coupon rate.
In short, the yield may be higher or lower than the coupon rate depending on how much you actually paid for the bond.
Using the previous example, if the bond is in high demand you might have to pay more than its face value to get it.
Let’s say that you paid P110,000 to invest in that 5% per annum, 5-year bond. While you will still get P25,000 plus your principal by maturity, the annual yield is now about 4.55%, because the amount that you paid was higher than the face value.
If you don’t consider this, you may not actually be getting the rate of returns that you expected.
Verdict: It depends (but mostly true).
For the most part, investors buying bonds at face value during their issuance get a yield that is the same as the coupon rate.
If, however, you pay more or less than the bond’s face value, it is best to consider the bond yield over the coupon rate. If you’ll have to pay a premium for the bond, the yield can still be a good thing even if it's lower than the coupon rate. It just depends on how much you need to achieve your goal.
