What Is a Coupon Rate?
A coupon rate is the nominal yield paid by a fixed-income security. It is the annual coupon payments paid by the issuer relative to the bond's face or par value. A coupon refers to the annual interest rate paid on a bond, paid from issue date through maturity.
Key Takeaways
- A coupon rate is the nominal yield paid by a fixed-income security.
- When a market ticks up and is more favorable, the coupon will yield less than the prevailing market conditions, as the value was determined during issuance and the bond will not pay more.
- When a bond is purchased on the secondary market, the yield to maturity (YTM) represents its remaining interest payments, which may be higher or lower than the bond's coupon rate when it was issued.
Understanding Coupon Rates
The coupon rate, or coupon payment, is the nominal yield the bond is stated to pay on its issue date. This yield changes as the value of the bond changes, thus giving the bond's yield to maturity (YTM).
The coupon rate is the interest rate paid on a bond by its issuer for the term of the security. The term "coupon" is derived from the historical use of actual coupons for periodic interest payment collections. Once set at the issuance date, a bond's coupon rate remains unchanged, and holders of the bond receive fixed interest payments at a predetermined time or frequency.A bond issuer decides on the coupon rate based on prevalent market interest rates, among other factors, at the time of the issuance. Market interest rates change over time, and as they move lower or higher than a bond's coupon rate, the value of the bond increases or decreases, respectively.
Changing market interest rates affect bond investment results. Since a bond's coupon rate is fixed all through the bond's maturity, a bondholder is stuck with receiving comparably lower interest payments when the market is offering a higher interest rate. An equally undesirable alternative is selling the bond for less than its face value at a loss. Thus, bonds with higher coupon rates provide a margin of safety against rising market interest rates.Coupon Rate Formula
A bond's coupon rate can be calculated by taking the sum of the security's annual coupon payments and dividing them by the bond's par value, then multiplying by 100 in order to be represented as a percent. The formula for coupon rate can be represented as:
(Sum of annual coupon payments / Par value) x 100 = Coupon rateFor example, a bond issued with a face value of $1,000 that pays a $25 coupon semiannually has a coupon rate of 5%. All else held equal, bonds with higher coupon rates are more desirable for investors than those with lower coupon rates. Excel software is also helpful for quickly calculating the bond's coupon rate.
Coupon Rate vs. Yield
When investors buy a bond initially at face value and then hold the bond to maturity, the interest they earn on the bond is based on the coupon rate set at issuance. For investors acquiring the bond on the secondary market, depending on the prices they pay, the return they earn from the bond's interest payments may be higher or lower than the bond's coupon rate. This is the effective return called yield to maturity (YTM). Another way to express this is that the current yield of a bond is coupon rate multiplied by the current price of the bond.
For example, a bond with a par value of $100 but traded at $90 gives the buyer a yield to maturity higher than the coupon rate. Conversely, a bond with a par value of $100 but traded at $110 gives the buyer a yield to maturity lower than the coupon rate.