The term ‘coupon’ is derived from the use of actual coupons for periodic interest payment collections. The coupon rate is yield paid by fixed-income security. The coupon rate is also called coupon payment. It is the yield the bond paid on its issue date. The yield changes when the value of the bond changes.
Such a case results in giving the bond’s yield to maturity. In the case of the booming market, the coupon holder yields lesser than the prevailing market conditions as bonds won’t pay more.
Yield to maturity comes into play when the bond is purchased on the secondary market and it is the difference in bond’s interest payments. The issuer of bonds decides on what coupon rate would be. This is based on prevalent market interest rates at the time of issue.
For example, Sinra Inc releases a bond worth $1,000 at issue. Every year it pays the holder $50. To calculate the bond coupon rate, total annual payments need to be divided by the bond’s par value.
Annual payments = $ 50
Coupon rate = $500 / $1,000 = 0.05
The bond’s coupon rate is 5 percent. This is the portion of bond that shall be paid every year.
How the Coupon Rate Affects the Price of a Bond?
Every type of bonds does pay interest to bondholder. Such amount of interest is called coupon rate of interest. The coupon rate is fixed over time.
For example, a bond with a face value of $1,000 and a 5% coupon rate pays $50 to the bondholder until its maturity. It does not matter if the bond price rises or falls in value over the period. The amount of coupon interest that is $ 50 needs to be paid for the lifetime of the bond until the day it matures.
If the market interest rate is greater than coupon rate of bond, the price of bond would fall as investors are likely to purchase bonds at face value now. This is because they would get better rate of return somewhere else.
Similarly, if market interest rates are lower than what bonds are paying, the price of the bond increases as it pays better than what the investor could make by purchasing another financial instrument.
Coupon Rate vs. Yield-to-Maturity
The coupon rate is the actual amount of interest paid annually while yield to maturity is the total rate of return to the bondholder if they hold it till maturity. Many investors assume yield to maturity a preferable item than coupon rate when they are making investment decisions.
The coupon rate remains the same over the lifetime of the bond while yield to maturity keeps changing. To compute yield to maturity, one must take into account the coupon rate and any increase or decrease in the price of the bond.
Example
if the face value of a bond is $1,000 and its coupon rate is 10%, the interest income equals $100. the interest income does not change irrespective of the climate of the economy.
Assume that the price of the bond increases to $1,500, then the yield-to-maturity changes from 10% to 6.67% ($100/$1,500).
If the price of the bond falls to $800, then the yield-to-maturity will change from 10% to 12.5% ( i.e., $100/$800). Here, yield to maturity equals the coupon rate only when the bond sells in the market at the par value. The bonds sell at a discount if the market price is lower than the par value. Then, yield to maturity shall be higher than the coupon rate.
Why Coupon Rates Vary?
When a company issues bonds for the first time in the market, it determines the coupon rate at or near the market interest rates to make it more competitive and attractive. This would also depend on the crediting rating of the company. The AAA-rated company would issue bonds with the lowest interest coupon rates.
Likewise, lower-rated companies would offer higher interest coupon rates as these companies are riskier than AAA-rated companies. Hence, the coupon rate of the bond is affected by two factors namely the market interest rates and the credit rating of the bond issuer.
Zero-Coupon Bonds
A zero-coupon bond is a bond without coupons, and its coupon rate is 0%. The issuer of zero-coupon bonds only pays the face value of bonds at the maturity date.
Instead of paying coupon interest, the bond issuer issues the bonds at price less than the face value. The discount of issue effectively represents the interest and yield for investors in zero-coupon bonds.
