Real Yield vs. Coupon: Why IRR Defines Your Fixed Income Strategy

When an investor faces the choice between two bonds, most make the same mistake: comparing only the coupon. A bond that pays 8% annually seems better than one with 5%, right? Not necessarily. This is where the YTM in fixed income comes into play, the metric that shows you the actual return you’ll get if you hold the asset until maturity.

The YTM: Your True Investment Compass

The Internal Rate of Return, or YTM, is a percentage that captures the full reality of your bond investment. It not only measures what you earn from periodic coupons but also the gain or loss you will realize from the difference between the purchase price and the face value you will recover at maturity.

Let’s imagine two scenarios with the same €1,000 nominal bond:

• Bought at €950 (below par): You will recover €1,000 at maturity. That extra €50 adds to your total return.
• Bought at €1,050 (above par): You will only recover €1,000 at maturity. Those €50 of premium reduce your final gain.

The YTM encompasses both situations in a single number, giving you the full picture.

Why is the YTM Different from the Coupon?

The difference between the coupon and the YTM is fundamental. The coupon is the nominal interest paid by the bond, fixed since issuance. The YTM, on the other hand, is dynamic: it depends on the current market price of the bond.

Let’s look at a practical example:

Bond A: Coupon of 8%, market price €105
Bond B: Coupon of 5%, market price €95

If you only looked at the coupon, you would choose A. But the fixed income YTM would show you that B offers a higher return because you’re buying it cheaper.

Comparing YTM with Other Interest Rates

To avoid confusion:

• YTM (Internal Rate of Return): Actual return of the bond considering current price and future cash flows.
• Nominal Interest Rate (Nominal Rate): The pure agreed-upon interest, without additional costs.
• APR (Annual Percentage Rate): Includes expenses, commissions, and insurance. It compares actual financing offers.
• Technical Interest: Used in insurance, includes costs of the insurance product.

In fixed income, the YTM is your most precise tool because it captures exactly your net gain.

How to Calculate the YTM: The Formula

The YTM formula requires solving an equation where the present value of all future cash flows equals the current purchase price:

P = C/(1+YTM) + C/(1+YTM)² + … + (C+N)/(1+YTM)ⁿ

Where:

• P = Current price of the bond
• C = Periodic coupon
• N = Face value
• n = Years until maturity

It’s not easy to solve this manually. Fortunately, online calculators do the work in seconds.

Practical Example 1: Bond Purchased Below Par

Bond trading at €94.5, annual coupon 6%, maturity in 4 years.

Applying the formula: YTM = 7.62%

Why does the YTM exceed the coupon? Because that initial discount of €5.5 generates additional profit.

Practical Example 2: Bond Purchased Above Par

The same bond, but at €107.5.

Applying the formula: YTM = 3.93%

Here, the 6% coupon is eroded by that €7.5 premium, reducing your actual return to less than half.

Factors That Shape the YTM in Fixed Income

Understanding what affects the YTM allows you to anticipate movements without complex calculations:

Coupon: The higher the coupon, the higher the YTM. The lower the coupon, the lower the YTM.

Purchase Price: Buying below par increases the YTM. Buying above par decreases it.

Special Features: Convertible bonds, inflation-linked bonds (FRN), or subordinated securities have additional sensitivities. For example, a convertible bond’s YTM will be affected by the performance of the underlying stock.

Fixed Income: YTM vs. Credit Risk

Here’s the most important warning. The YTM shows profitability but does not eliminate risk. During Greece’s 2015 crisis, Greek 10-year bonds yielded over 19% YTM. It seemed like a bargain. In reality, it was a trap: it reflected the real risk of Greece defaulting.

Only the Eurozone bailout prevented those bonds from becoming worthless. Therefore, when evaluating any fixed income investment, the YTM should always be accompanied by a thorough analysis of the issuer’s credit quality.

Conclusion: The YTM is Your Ally in Fixed Income

The YTM is the metric you need to master to make informed decisions in fixed income. It allows you to compare bonds objectively beyond just the nominal coupon. But remember: an attractive YTM without the issuer’s credit stability is a dangerous illusion. Use the YTM as a compass, but never forget to verify the ground you stand on.