Beginning investor in bonds often get confused with coupon interest rate (coupon rate) and yield rate (market interest rate). We will break out those terms to help you get used to with its.
- Coupon rate: This is a fixed rate to calculate future payment of bond from issue to maturity date. For example, if the coupon rate is 5% for a bond of $1000 value with maturity time is 10 year, you will receive 5% * $1000 = $50 payment every year.
- Bond payment actually paid by semi-annual so you will receive $25 ( $50/2) payment every 6 months, this is your fixed income for the 10-year bond investment. Not too shabby.
- Yield: This is a dynamic rate, it’s calculated by divide your fix annual coupon payment ($50) of a dynamic bond market price.
- If the bond price going up to $1500 your yield (%) will be $50/$1500 = 3,3%
- If the bond price drop to $750, yield (%) = $50 / $750 = 6,7%
- This yield is market interest rate and it can go up and down as market volatility.
Since bonds are considered liquid, investors tend to sell their bond with yield is 3,3% and buy other at higher yield of 6,7%.
Yield is an important number for bond issuers and investors, when yield drop investor will sell (put-table) bond (often at a lower price than face value), when yield high-rise issuer can buy back their bonds (callable) at the premium price (higher than face value).
The rule of thumb is buying bond with coupon rate is higher than market interest rate (or general interest rate).