A bond’s coupon rate represents the annual interest rate paid by the issuer, as determined by current market interest rates and based on the bond’s face value. Bond issuers typically pay coupon rates on a semiannual basis.
The coupon rate of a bond can tell an investor how much interest they can expect to collect on a yearly basis. The bond coupon rate is not the same as the bond yield, which investors who buy bonds on the secondary market use to estimate the total rate of return at maturity.
Investment-quality bonds can help with diversification in a portfolio while providing a consistent stream of interest income. Understanding the coupon rate and what it means is important when choosing bonds for your portfolio.
What Is the Coupon Rate?
Bonds represent a debt where the bond issuer borrows money from investors and agrees to pay interest at regular intervals in exchange for the use of their capital. Both governments and non-government entities, like corporations, may issue bonds to raise capital to fund various endeavors.
The coupon rate of a bond is usually a fixed interest rate, typically paid out twice per year. That said, there are some variable-rate bonds, as well as zero-coupon bonds (more on those below). Investors often use the term “coupon rate” when discussing fixed-income securities, including bonds and notes.
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The Role of Coupon Rates in Bond Investments
Investors can buy individual bonds, bond funds, or bond options, which are derivatives similar to stock options.
The coupon interest rate tells you what percentage of the bond’s face value, or par value, you’ll receive yearly. The rate won’t change during the life of the bond, which is why some bonds are worth more than others on the secondary market.
Coupon rates are typically lower for investment-grade bonds and higher for junk bonds, due to their higher risk.
Example of a Bond’s Coupon Rate
Assume you purchase a bond with a face value of $1,000. The bond has a coupon rate of 4%. This means that for each year you hold the bond until maturity, you’d receive $40, regardless of what you paid for the bond.
If you buy a bond on the secondary market, the story changes somewhat. That’s because bonds trade either at a premium to the par value (higher than the face value), or at a discount to par (lower than the face value). Because the coupon rate of the bond stays the same until maturity, it may represent a higher or lower percentage of the par value — this is called the yield.
History of the Term Coupon
Bond holders used to get literal coupons as a way of collecting their interest payments. This is no longer the case, as interest is paid on a set schedule to the investor directly.
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Calculating the Coupon Rate
The bond coupon rate formula is fairly simple:
Bond coupon rate = Total annual coupon payment/Face or par value of the bond x 100
To apply the coupon rate formula you’d need to know the face or par value of the bond and the annual interest or coupon payment. To find this payment, you’d multiply the amount of interest paid by the number of periodic payments made for the year. You’d then divide that by the par value and divide the result by 100.
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Step-by-Step Calculation of the Coupon Rate
Say you have a bond with a face value of $1,000, which pays $25 in interest to you twice per year.
• To find the annual coupon payment you’d multiply $25 by two to get $50.
• You’d then divide the $50 annual coupon payment by the $1,000 par value of the bond. 50 / 1000 = 0.05
• Then multiply the result by 100 (0.05 x 100) to find that your bond has a coupon rate of 5%.
The Impact of Market Interest Rates on Coupon Rates
How is the coupon rate determined? This is where current market interest rates come into play.
How Interest Rate Fluctuations Affect Bonds
Interest rates can influence coupon rates. An interest rate is the rate a lender charges a borrower. Individual lenders determine interest rates, often based on movements in an underlying benchmark rate. When discussing bond coupon rates and interest rates, it’s typically in the context of changes to the federal funds rate. This is the rate at which commercial banks lend to one another overnight.
Movements in the federal funds rate directly influence other types of interest rates, including coupon rates and bond prices on the secondary market.
When interest rates rise, based on changes to the federal funds rate, that can cause bond prices to fall. When interest rates decline, bond prices typically rise. When bond prices change that doesn’t impact the coupon rate, which stays the same. But a bond’s price is an important consideration for investors who trade on the secondary market because it impacts the yield to maturity.
Strategies for Investors in a Changing Rate Environment
Bond prices can move up or down based on the coupon rate, relative to movements in interest rates.
When interest rates are higher than the bond’s coupon rate, that bond’s price may fall in order to offset a less attractive yield. If interest rates drop below the bond’s coupon rate, the bond’s price may rise if it becomes a more attractive investment opportunity.
When comparing coupon rates and bond prices, it’s important to understand the relationship between the bond’s face value and what it trades for on the secondary market. If a bond is trading at a price above its face value, that means it’s trading at a premium to par. Conversely, if a bond is trading at a price below its face value, that means it’s trading at a discount to par.
An investor who purchases a bond with the intent to hold it until it reaches maturity does not need to worry about bond price movements. Their end goal is to collect the annual interest payments and recover their principal on the assigned maturity date, making it a relatively safe investment as long as the issuer fulfills their obligation.
Investors looking to buy bonds and resell them before they mature, however, may pay attention to which way bond prices are moving relative to the coupon rate to determine whether selling would yield a profit or loss.
Understanding Coupon Rate vs. Yield
Coupon rate tells investors how much interest a bond will pay yearly until maturity. But there are other metrics for evaluating bonds, including yield to maturity and interest rates. Understanding the differences in what they measure matters when determining whether bond investments are a good fit and what rate of return to expect.
Coupon Rate vs. Yield to Maturity
A bond’s yield to maturity or current yield reflects the interest rate earned by an investor who purchases a bond at market price and holds on to it until it reaches maturity. A bond’s maturity date represents the date at which the bond issuer agrees to repay the investor’s principal investment. Longer maturity dates may present greater risk, as they leave more room for the bond issuer to run into complications that could make it difficult to repay the principal.
When evaluating yield to maturity of a bond, you’re looking at the discount rate at which the sum of all future cash flows is equal to the price of the bond. Yield to maturity can be quoted as an annual rate that’s different from the bond coupon rate. In figuring yield to maturity, there’s an assumption that the bond issuer will make coupon and principal payments to investors on time.
The coupon rate is the annual interest earned while yield to maturity reflects the total rate of return produced by the bond when all interest and principal payments are made.
Coupon Rate vs Interest Rate
While coupon rate and interest rate seem similar, they are distinct. The coupon rate is set by the issuer of the bond, and the amount paid to the bondholder is tied to the face value.
But the prevailing interest rate set by the government is what determines the coupon rate. If the central bank, i.e. the Federal Reserve, sets the interest rate at 6%, that will influence what lenders are willing to accept in the form of the coupon rate.
Also, the price of a bond on the secondary market hinges on the coupon rate. A higher-coupon bond is more desirable than a lower-coupon bond, so its price will be higher.
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Variable-Rate and Zero-Coupon Bonds
Not all coupon rates are fixed. Investors can also consider whether buying variable-rate bonds or zero-coupon bonds might make sense.
Fixed vs. Variable Coupon Rates and Investment Impact
Although bonds typically offer fixed-income payments, some bonds do offer coupon rates that adjust periodically. For that reason these bonds are sometimes called floating-rate or adjustable-rate bonds.
In these cases, the coupon rate adjusts according to a formula that’s linked to an interest rate index such as the SOFR (Secured Overnight Financing Rate), the new benchmark in the U.S. that has largely replaced the LIBOR (London Interbank Offered Rate).
Although these are income-producing bonds, and there is always the possibility that they could offer a higher yield under the right conditions, they are not technically fixed-income instruments, which is something for investors to bear in mind. In addition they come with the risk of default.
Zero-Coupon Bonds Explained
Some bonds, called zero-coupon bonds, don’t pay interest at all during the life of the bond. The upside of choosing zero bonds is that by forgoing annual interest payments, it’s possible to purchase the bonds at a deep discount to par value. This means that when the bond matures, the issuer pays the investor more than the purchase price.
Zero-coupon bonds typically have longer maturity dates, which may make them suitable when investing for long-term goals. This type of bond may experience more price fluctuations compared to other types of bonds sold on the secondary market. Investors may still have to pay taxes on the imputed interest generated by the bond, though it’s possible to avoid that by investing in zero-coupon municipal bonds or other tax-exempt zero-coupon bond options.
The Takeaway
Investing in bonds can help you create a well-rounded portfolio alongside stocks, and other securities, which is why knowing the coupon rate of a bond is important. The coupon rate is the interest rate paid by the issuer, and it’s fixed for the life of the bond — which makes it possible to create a predictable income stream, whether you buy the bond at issuance or on the secondary market.
As you get closer to retirement, bonds can be an important part of your income and risk management strategy, whether you’re investing through an IRA, a 401(k), or a brokerage account.
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