Interest rate is the amount of interest expressed as a percentage of a bond’s face value. Yield to maturity is the actual rate of return based on a bond’s market price if the buyer holds the bond to maturity.
Nominal (Coupon) Interest Rate
Most bonds are issued with a fixed interest set in dollars that the issuer promises to pay to the bondholder annually until maturity. The interest rate is the interest expressed as a percentage of the bond’s face value (par). Most bonds are issued in $1,000 denominations. A five-percent bond will pay $50 on each $1,000 of face value until maturity.
Bond Prices Fluctuate
Once issued, bonds trade in the secondary market. Their prices fluctuate depending on interest rates, credit rating changes, the financial affairs of the issuer and general market conditions. A $1,000 face value bond can trade at a discount (less than its face value) or at a premium (more than its face value). For example, if interest rates drop, a five-percent bond may be priced at $1,100.
Investor Return Varies
An investor who buys a five-percent coupon $1,000 face value bond for $1,100 will still collect the $50 in annual interest but his rate of return will obviously be less because he paid more for the bond.
A 20-year bond may have only 10 years left until maturity, which will also affect the amount of money the investor will have collected.
Yield to Maturity
Let’s say an investor buys a 20-year five-percent coupon bond for $1,100. The bond has 10 years left until maturity. At maturity, the investor will receive the full face value--$1,000, which is $100 less than he paid for the bond. The difference is accounted for as a loss prorated annually, in this case: $10. So the net return the investor will realize is $40. The average price of the bond is $1,100 (purchase price) plus $1,000 (face value), divided by 2 equals $1,050. The yield to maturity is $40 (net annual return) divided by $1,050 (average price) equals 3.8 percent.
The Rule of Thumb
Yield to maturity is always less than the interest rate when a bond is traded at a premium and more when the bond is traded at a discount.