The coupon rate is the amount of annual interest income paid to a bondholder, based on the face value of the bond. Government and non-government entities issue bonds to raise money to finance their operations. When a person buys a bond, the bond issuer promises to make periodic payments to the bondholder, based on the principal amount of the bond, at the coupon rate indicated in the issued certificate. The issuer makes periodic interest payments until maturity when the bondholder’s initial investment – the face value (or “par value”) of the bond – is returned to the bondholder.
Formula for Calculating the Coupon Rate
C = Coupon rate
i = Annualized interest
P = Par value, or principal amount, of the bond
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How the Coupon Rate Affects the Price of a Bond
All types of bonds pay interest to the bondholder. The amount of interest is known as the coupon rate. Unlike other financial products, the dollar amount (and not the percentage) is fixed over time. For example, a bond with a face value of $1,000 and a 2% coupon rate pays $20 to the bondholder until its maturity. Even if the bond price rises or falls in value, the interest payments will remain $20 for the lifetime of the bond until the maturity date.
When the prevailing market interest rate is higher than the coupon rate of the bond, the price of the bond is likely to fall because investors would be reluctant to purchase the bond at face value now, when they could get a better rate of return elsewhere. Conversely, if prevailing interest rates fall below the coupon rate the bond is paying, then the bond increases in value (and price) because it is paying a higher return on investment than an investor could make by purchasing the same type of bond now, when the coupon rate would be lower, reflecting the decline in interest rates.
Coupon Rate vs. Yield-to-Maturity
The coupon rate represents the actual amount of interest earned by the bondholder annually, while the yield-to-maturity is the estimated total rate of return of a bond, assuming that it is held until maturity. Most investors consider the yield-to-maturity a more important figure than the coupon rate when making investment decisions. The coupon rate remains fixed over the lifetime of the bond, while the yield-to-maturity is bound to change. When calculating the yield-to-maturity, you take into account the coupon rate and any increase or decrease in the price of the bond.
For example, if the face value of a bond is $1,000 and its coupon rate is 2%, the interest income equals $20. Whether the economy improves, worsens, or remains the same, the interest income does not change. Assuming that the price of the bond increases to $1,500, then the yield-to-maturity changes from 2% to 1.33% ($20/$1,500= 1.33%). If the price of the bond falls to $800, then the yield-to-maturity will change from 2% to 2.5% ( i.e., $20/$800= 2.5%). The yield-to-maturity only equals the coupon rate when the bond sells at face value. The bond sells at a discount if its market price is below the par value. In such a situation, the yield-to-maturity is higher than the coupon rate. A premium bond sells at a higher price than its face value, and its yield-to-maturity is lower than the coupon rate.
The yield-to-maturity figure reflects the average expected return for the bond over its remaining lifetime until maturity.
Why Coupon Rates Vary
When a company issues a bond in the open market for the first time, it pegs the coupon rate at or near prevailing interest rates in order to make it competitive. Also, if a company is rated “B” or below by any of the top rating agencies, then it must offer a coupon rate higher than the prevailing interest rate in order to compensate investors for assuming additional credit risk. In short, the coupon rate is affected by both prevailing interest rates and by the issuer’s creditworthiness.
The prevailing interest rate directly affects the coupon rate of a bond, as well as its market price. In the United States, the prevailing interest rate refers to the Federal Funds Rate that is fixed by the Federal Open Market Committee (FOMC). The Fed charges this rate when making interbank overnight loans to other banks and the rate guides all other interest rates charged in the market, including the interest rates on bonds. The decision on whether or not to invest in a specific bond depends on the rate of return an investor can generate from other securities in the market. If the coupon rate is below the prevailing interest rate, then investors will move to more attractive securities that pay a higher interest rate. For example, if other securities are offering 7% and the bond is offering 5%, then investors are likely to purchase the securities offering 7% or more to guarantee them a higher income in the future.
Investors also consider the level of risk that they have to assume in a specific security. For example, if an early-stage company or an existing company with high debt ratios issues a bond, investors will be reluctant to purchase the bond if the coupon rate does not compensate for the higher default risk. There is no guarantee that a bond issuer will repay the initial investment. Therefore, bonds with a higher level of default risk, also known as junk bonds, must offer a more attractive coupon rate to compensate for the additional risk.
Bonds issued by the United States government are considered free of default risk and are considered the safest investments. Bonds issued by any other entity apart from the U.S. government are rated by the big three rating agencies, which include Moody’s, S&P, and Fitch. Bonds that are rated “B” or lower are considered “speculative grade,” and they carry a higher risk of default than investment-grade bonds.
A zero-coupon bond is a bond without coupons, and its coupon rate is 0%. The issuer only pays an amount equal to the face value of the bond at the maturity date. Instead of paying interest, the issuer sells the bond at a price less than the face value at any time before the maturity date. The discount in price effectively represents the “interest” the bond pays to investors. As a simple example, consider a zero-coupon bond with a face, or par, value of $1,200, and a maturity of one year. If the issuer sells the bond for $1,000, then it is essentially offering investors a 20% return on their investment, or a one-year interest rate of 20%.
$1,200 face value – $1,000 bond price = $200 return on investment when the bondholder is paid the face value amount at maturity
$200 = 20% return on the $1,000 purchase price
Examples of zero-coupon bonds include U.S. Treasury bills and U.S. savings bonds. Insurance companies prefer these types of bonds due to their long duration and due to the fact that they help to minimize the insurance company’s interest rate risk.