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Understanding Coupon Rate and Yield to Maturity of Bonds

what is compound interest and how does it work security bank philippines

Coupon Rate


The Coupon Rate is the amount that you, as an investor, can expect as income as you hold the bond. The coupon rate for each bond is fixed upon issuance. Here’s a sample computation for a Retail Treasury Bond issued by the Bureau of Treasury:

Security Name Coupon Rate Maturity Date
RTB 03-11 2.375% 3/9/2024

The Coupon Rate is the interest rate that the bond pays annually, gross of applicable taxes. The frequency of payment depends on the type of fixed income security. In the above example, a Retail Treasury Bill (RTB) pays coupons quarterly. To translate this to quarterly payment, first, multiply the coupon rate net of 20% final withholding taxes by the face value (1.900% x 1,000,000). Then, divide the resulting annual amount by 4. Here’s a sample of how you can compute your expected coupon income from your bond:

Face Value 1,000,000
Coupon Rate 2.375%
Coupon Amount (Net 20% of Taxes) 1.900%
Coupon Amount (Yearly Gross of Taxes) 23,750.00
Coupon Amount (Yearly Net of 20% Taxes) 19,000.00
Coupon Amount (Quarterly) 4,750.00

Php 4,750.00 is the income you can expect to receive quarterly. Do note, however, that if your account is entitled to tax exemption then the calculation for coupon pay- ment will exclude the final taxes.

Yield-to-Maturity


The Yield to Maturity is a rate of return that assumes that the buyer of the bond will hold the security until its maturity date and incorporates the rise or fall of market interest rates. This will be a bit technical. Let’s see what happens to your bond when interest rates in the market move.

When bonds are initially issued in the primary market, the Coupon Rate is based on current market rates, hence YTM is equal to the coupon rate. In the example bond above, when you bought the 3-year RTB issued at the primary market, your YTM and coupon rate is 2.375%. Now, what if you bought the security in the secondary market? The resulting YTM will differ from the coupon rate. This is simply because interest rates change daily. To prove this point, say a month later you decide to purchase the same RTB 03-11 in the secondary market. However, Interest rates increased. From 2.375%, quoted yield increased to 2.700%. Let’s see how much you’d have to pay for the same security you bought a month ago:

Security Name Coupon Rate Maturity Date Coupon Frequency YTM Face Value Clean Price Market Value
RTB 03-11 2.375% 3/9/2024 4 2.700% 1,000,000 99.03 992,494.26

Notice that the bond is now worth 992,494.26, cheaper compared to a month ago. That’s how much you’ll buy the bond with a Php 1,000,000 Face Value. You can infer here that as market interest rates rise, the market value of the bond decreases. If market interest rates decrease, the value of your bonds rises. We call this an inverse relationship between bond value and interest rates. We attached the Excel file for the computation so you can check how the bond moves.

So, the YTM is a good indicator of the value of your bond, right? The Coupon Rate still gives valuable information. First, the coupon rate shows you the exact cash flow that you’ll get based on the Face Value. This rate also shows you what interest rates were at that time of the bond’s issuance. It’s good for initial analysis on interest rate movement. It also matters that coupon bonds will let you receive better cash flows based on the investment horizon. But this is a lesson we’ll tackle next time.

Key Takeaway


So now we have a better understanding of why brokers quote the bonds in terms of Yield to Maturity. Again, this is because the YTM reflects the current market rates and the value of your bond. If you want to know how your bonds fair in the market, check out the relevant yield for the tenor of the bond you are holding using our Securities Calculator.

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