Coupon Rate - Explained
What is a Coupon Rate?
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Table of ContentsWhat is a Coupon Rate?How Does the Coupon Rate Work?How to Calculate Coupon RateExample of Coupon RateAbout the Interest RateAbout Market RateAbout Yield to Maturity
What is a Coupon Rate?
A coupon rate refers to the annual interest amount that a bondholder receives usually based on the bonds face value. A coupon rate is the bond interest an issuer pays to a bondholder on its issue date. Any change in the value of the bond changes the yield, a situation that gives yield to maturity of the bond.
How Does the Coupon Rate Work?
Both government and non-government entities raise money through bonds to fund their operations. When you buy a bond, there is a promise from the bond issuer that he or she will make periodic payments to you as the bondholder. The payment you will receive is, however, based on your bonds principal amount, and at the coupon rate as reflected in the issued certificate. The issuer will pay interest on an annual basis until maturity. Maturity is when you get back your initial investment and the par value of the bond
How to Calculate Coupon Rate
Generally, investors will always prefer bonds that have a high coupon rate over those with low coupon rates, not unless they are all held equal. To calculate the coupon rate, you first have to divide the sum of the security's yearly coupon payment. You then divide them by the par value of the bond.
Example of Coupon Rate
Lets assume that Eddie has a 10-year bond of ABC Company with $10,000 as the nominal value and a maturity period of 20 years. The interest rate is 8% per year. The current yield for the coupon is 5.22%, while 3.85% is the yield to maturity. Now let us find out how much Eddie will receive as his coupon payment. Each bond has a coupon payment of $1,000x 8/100 = $80. As a bondholder, Eddie will receive $80 as his interest payment. Note that the coupon payment Eddie receives is calculated at the interest rate of the bond, and not current yield of the bond. Remember that Eddies bond maturity period is 20 years. So, after the 20 years elapses, Eddie will receive his bonds principal value of $1,000 with the coupon rate.
About the Interest Rate
Coupon rate refers to the interest rate on the bond that the issuer pays throughout the bond term. You can trace the term 'coupon' back to the historical use of actual coupons for periodic interest payment collections. Note that the moment the interest rate is set at the date of issuance, there is no changing the bonds coupon rate. Its holders will be receiving fixed interest payments at the same time every year until it reaches yield to maturity. It is the bond issuer who decides on the coupon rate, which is based on the prevailing market interest rates. Note that there is always a change in the market interest rates over time. Sometimes the rates may move either lower or higher than the coupon rate of the bonds. So, the bonds value may decrease or increase, respectively.
About Market Rate
Changes in the market interest rates affect the results of a bond investment. The bondholder is likely to receive a low-interest payment if the market interest rates happen to be higher. It is because the coupon rate of the bond is usually fixed throughout the maturity of the bond. An alternative is for the bondholder to sell the bond at a price below its face value On the other hand, if the market rate happens to be below the coupon rate of the bond, it is beneficial for investors to hold it. The reason is that other investors are likely to buy the bonds at a price way above its face value. So, bonds with higher coupon rates have a safe margin against the increasing market interest rates.
About Yield to Maturity
When investors purchase bonds at face value and are held up to maturity, the interest they will earn on the bonds will depend entirely on the coupon rates, predetermined at the issuance. For those investors that buy bonds on a secondary market, they are likely to earn a higher or lower interest rate from the bond. It all depends on the prices investors will pay.