Why Default-Free Bonds with Same Maturity Have Different Yields

It might seem a bit puzzling at first. We have two bonds that are both considered default-free, meaning there’s no risk the issuer won’t pay you back. They also both mature on the exact same date. Logically, you might think they should offer the same return, but that’s not always the case, and the key lies in understanding what yield to maturity actually represents and how different bond characteristics can influence it.

Think of a bond’s yield to maturity as the total return you can expect to receive if you hold the bond until it matures, taking into account all the coupon payments you’ll receive over time and the difference between what you paid for the bond and its face value, which you’ll get back at maturity. It’s like the overall annual percentage return on your investment in that bond.

Now, let’s consider the coupon payments. Coupon bonds, as the name suggests, pay out regular interest payments, called coupons, to the bondholder. These payments are usually made semi-annually. The coupon rate, expressed as a percentage of the bond’s face value, determines the size of these payments.

Imagine two fruit baskets. Both baskets are guaranteed to be delivered on the same date next year, and you’re certain they’ll both arrive as promised. However, one basket, let’s call it Basket A, is filled with a lot of fruit that ripens quickly. It gives you more fruit upfront, maybe several apples and oranges right now, and then a smaller delivery of fruit closer to the delivery date. Basket B, on the other hand, has less fruit right now, maybe just a few pears, but promises a much larger delivery of exotic fruits closer to the final delivery date.

In this analogy, the fruit delivered right away is like the coupon payments from a bond. Basket A represents a bond with a higher coupon rate. It gives you more income sooner. Basket B represents a bond with a lower coupon rate. It gives you less income now but potentially a greater return later in a different form.

Bonds with higher coupon rates provide more of their total return through these regular coupon payments. Bonds with lower coupon rates, conversely, provide more of their return through the difference between their purchase price and the face value they pay back at maturity. This difference is known as capital appreciation if you buy the bond at a discount, or capital depreciation if you buy at a premium.

Let’s say both bonds have a face value of $1,000 and mature in five years. Bond X has a 5% coupon rate, and Bond Y has a 2% coupon rate. Bond X will pay out larger coupon payments each year than Bond Y. To compensate for this lower stream of coupon income, Bond Y would likely be priced at a discount to its face value. Perhaps Bond X trades closer to $1,000, while Bond Y trades at $900.

When you calculate the yield to maturity, you’re considering both the coupon payments and this price difference. Even though Bond X provides more income upfront through coupons, Bond Y offers the potential for a larger capital gain as its price will rise to $1,000 at maturity. These different cash flow patterns, driven by varying coupon rates, can result in different yields to maturity, even for bonds with the same maturity date and the same default-free status.

Another way to think about it is the reinvestment risk. With a higher coupon bond, you receive larger coupon payments earlier. You then need to reinvest these payments. The yield to maturity calculation assumes you can reinvest these coupons at the same yield to maturity rate. However, if interest rates fall after you receive those coupon payments, you might not be able to reinvest them at the same attractive rate, potentially impacting your overall realized return. Lower coupon bonds have less reinvestment risk because a smaller portion of their return comes from coupon payments.

So, while both bonds are default-free and mature at the same time, their different coupon rates create distinct cash flow streams and price dynamics, leading to potentially different yields to maturity. Investors might prefer bonds with different coupon rates depending on their individual needs and expectations about future interest rates and their desired balance between current income and potential capital appreciation. Understanding this relationship is crucial for navigating the bond market effectively.