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What Is a Coupon Rate?
Let me explain this directly: a coupon rate is the nominal yield that a fixed-income security like a bond pays out. It's the annual coupon payments from the issuer, calculated relative to the bond's face or par value. Think of the coupon as the annual interest rate the bond pays from the day it's issued until it matures.
Key Takeaways
- A coupon rate is the nominal yield paid by a fixed-income security.
- As market interest rates fluctuate, the resale value of a bond rises or falls, depending on how attractive its coupon rate is compared with the market rate.
- 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
You need to know that the coupon rate, or coupon payment, is the nominal yield stated on the bond at issuance. This yield shifts as the bond's value changes, leading to what's called the yield to maturity (YTM).
Essentially, the coupon rate is the interest rate the issuer pays on the bond for its entire term. The term 'coupon' comes from old-school bonds where you'd clip actual coupons to collect interest. Once set at issuance, this rate doesn't change, and you, as the holder, get fixed interest payments at set times.
Issuers pick the coupon rate based on current market interest rates and other factors at launch. But market rates move up or down over time, and if they go higher than your bond's coupon, the bond's value drops. If they go lower, the value rises. You're stuck with lower payments if rates rise, or you sell at a loss. That's why higher coupon rates give you some buffer against rising rates.
Important Note
Here's a key point: if market rates drop below your bond's coupon rate, the bond's market price goes up. Other investors will pay more than face value for that higher coupon.
Coupon Rate Formula
To calculate it, take the sum of the annual coupon payments, divide by the par value, and multiply by 100 for the percentage. The formula is: Coupon Rate = (Sum of annual coupon payments / Par value) x 100.
For instance, a $1,000 bond paying $25 semiannually has a 5% coupon rate. All things equal, you want bonds with higher rates—they're more appealing. You can use Excel for quick calculations too.
Coupon Rate vs. Yield
If you buy a bond at face value and hold to maturity, your interest is based on the coupon rate set at issuance. But on the secondary market, what you pay affects your return, which could be above or below the coupon rate—that's the yield to maturity (YTM). Or think of current yield as annual coupon divided by current price.
Say a $100 par bond trades at $90: your YTM is higher than the coupon. At $110, it's lower.
Example of Coupon Rates
Take a bond with $100 par and 3% coupon—it pays $3 annually. Buy it at $90 on secondary, you still get $3, so current yield is 3.33%. Buy at $110, yield drops to 2.73%.
Explain Like I'm Five
A coupon is the interest payment you get as a bondholder until maturity. The rate is that as a percentage: a $200 bond at 3% means $6 yearly. The rate is fixed at issue, but other bonds' rates change with the market, so your bond's resale value shifts. Low market rates make high-coupon bonds valuable; high rates make low-coupon ones cheap.
How Are Coupon Rates Affected by Market Interest Rates?
Issuers set the rate based on market rates at issuance, plus other factors. As market rates change, if they rise above the coupon, bond value falls; if below, it rises. Higher coupons protect against rate hikes.
What's the Difference Between Coupon Rate and YTM?
Coupon rate is the fixed annual income from the bond, sum of coupons over par value. At issuance, YTM equals coupon rate. YTM is the return if held to maturity, summing remaining payments, varying with market price and payments left.
What Is the Effective Yield?
Effective yield assumes reinvesting coupons at the same rate—it's the total return with compounding, unlike the nominal coupon rate.
The Bottom Line
In summary, the coupon rate is the interest the issuer pays on the bond until maturity, set based on issuance market rates. It stays fixed, with payments at set times. Market changes adjust the bond's resale value based on coupon attractiveness, while YTM varies with price and remaining payments.
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