What is a Coupon Rate? The Definition and Its Calculation
Fixed income securities, or bonds, are considered safer investments but yield lower returns. They are common among risk-averse investors, well-diversified portfolios, pension funds, and passive income generation portfolios. When investors evaluate bonds to add to their portfolios, they must consider three defining aspects: the bond issuer, the yield to maturity, and the coupon rate.
We will define the coupon rate, examine the yield to maturity vs. coupon rate difference, and show you how to calculate coupon rates.
What is a Coupon Rate - Explained
A coupon rate refers to annual payments a bond issuer must make to investors. Bonds are fixed-income securities, meaning the scheduled payments are fixed irrelevant of market conditions and set during the purchase. The underlying bond price can change due to market conditions, but the coupon payment remains fixed, affecting the bond yield.
Investors who purchase bonds in the secondary market can benefit from changing market conditions, as they may find higher-value opportunities. When favorable conditions exist, the bond yield will drop as the payment is fixed, but when market conditions worsen, bond yields rise.
When current bond prices trade above the issuance value, they are at a premium, and when they drop below, they are at a discount. Bonds that trade at a premium yield less but offer downside protection, while bonds at a discount yield more but carry additional risks.
For bond investors, the coupon rate is their income, as they receive their initial bond investment at the end of maturity. Bond traders in the secondary market earn from discounts on bonds when buying and selling them and consider the yield to maturity, which reflects changes in bond prices.
Understanding How a Coupon Rate Works
The coupon rate of a bond is the income investors earn, stated during the issuance of a bond, and fixed, unless the bond offers a variable coupon rate tied to a publicly distributed yield, for example, LIBOR.
Here is an example of a fixed coupon rate:
- An entity sells a 5-year $2,000 bond with a 3% coupon rate, paid semi-annually
- The investor will receive $30 payments every six months for five years
- At the end of the period, the investor gets the $2,000 back
- The $60 annual payments remain fixed, in our example, distributed at biannual payments of $30
- The investor will always get the $30 bi-annual coupon payments unless the issuing entity defaults, even if the bond price rises to $2,100 or drops to $1,900
- The bond yield changes as bond prices move, a factor bond traders consider in the secondary market
Below is a zero-coupon rate example:
- A zero-coupon rate bond does not pay an annual coupon rate
- It has longer maturity dates and greater volatility but sells for a discount
- An entity sells a 20-year zero-coupon rate bond at $5,000
- The investor earns no interest during the 20 years but receives $30,000 at the maturity date
- It represents a fixed-income investment, and a zero-coupon bond is also known as a discounted cash flow investment
- Given longer maturity dates, investors must ensure their counterparty is trustworthy and able to pay the bond in 20 years, usually developed country governments
The Calculation of a Coupon Rate
Calculating coupon rate differentials can help investors select higher-yielding bonds. The fixed-income market delivers lower returns due to the lower risk profile, especially if investors buy bonds from governments with an established track record and minimal default risk. Bond yields increase for riskier investments, compensating investors for accepting more risk, for example, from debt-heavy counterparties.
The coupon rate formula is:
C = i / P
- C is the coupon rate
- i is the annualized interest rate
- P is the principal bond amount or par value
The coupon value formula reflects bond price movements. It does not affect bond investors in the primary market, as coupon payments remain fixed for the bond duration. Bond traders evaluate changing bond yields to spot profitable opportunities in the secondary market.
Here is a coupon rate formula example:
- An entity issues a $10,000 bond with an annual coupon payment of $450
- The coupon rate for this bond is 4.50% ($450 / $10,000)
Advantages of a Coupon Rate
A coupon rate presents a simple, percentage-based indicator of guaranteed annual returns. It allows portfolio managers to compare bonds to other fixed-income products, compute portfolio allocation to meet desired cash flow, and weigh it against higher-risk-higher-reward alternatives to achieve appropriate risk profiles.
Retirement and passive income portfolios heavily rely on stable, guaranteed cash flow, and the coupon rate highlights risk and reward in fixed income.
Does the Coupon Rate Affect the Bond Price?
The coupon rate does not affect the bond price, but market interest rates will move bond prices, affecting bond yields. When an entity issues a bond, for example, a 2-year, $1,000 bond with a coupon rate of 3.50%, the investors will receive $35 annually.
The 3.50% coupon rate does not affect the $1,000 bond price, and the $35 annual payment remains fixed. Market interest rates impact the initial coupon rate, as bond prices compete with interest rates. Riskier bonds offer premiums to compensate investors for the additional risks.
At the issuance date, the bond yield in our example is 3.50%. Market conditions will move bond prices, changing the bond yield, but the payment of $35 remains fixed. Bond investors should care about the trustworthiness of the issuing party and the attractiveness of the coupon rate versus interest rates. Bond traders will evaluate bond yields and prices as they benefit from changing market conditions.
Here is an example:
- A $1,000 bond with a 3.50% coupon rate pays $35, yielding 3.50%
- If the bond price increase to $1,050, the payment remains $35, but the bond yield drops to 3.33%
- If the bond price decreases to $950, the bond yield rises to 3.68%, but the $35 annual payment remains fixed
What is the Difference Between Yield to Maturity, Coupon Rate, and Interest Rate?
Central banks set the interest rate, and bond issuers consider it when deciding on the coupon rate. When evaluating the coupon rate vs. the interest rate, the former yields more to attract investors.
The coupon rate reflects the annual interest earned by bondholders, and the yield to maturity considers changes in bond prices. Investors prefer it when evaluating the attractiveness of the bond investment. During issuance, both are equal, but over time, they divert.
Coupon Value Conclusion
Understanding the coupon rate definition will help bond investors calculate the coupon value and help them make more informed investment choices. What is a coupon rate? It is the interest rate paid by the issuer to investors. As market conditions change, the bond price changes, impacting the yield and changing the bond value. Bond yields reflect market conditions, but bond payouts remain fixed, hence the term fixed-income investment. A coupon rate reflects the amount investors can earn, allowing them to plan their cash flow if they hold the bond.
What is a zero-coupon rate?
A zero-coupon rate refers to a bond that does not pay interest rates but a higher payout at the end of maturity.
Is the coupon rate the same as the interest rate?
The coupon rate is the income generated by a bond investment, but central banks set the interest rate. While coupon rates consider the interest rate environment to offer a competitive alternative, they are not the same.
Is a higher coupon rate better?
A higher coupon rate suggests higher payments but also includes higher risk. Therefore, it depends on the risk appetite of investors.
Should I buy bonds when interest rates are low?
Buying bonds in a low-interest-rate environment will yield low returns, as coupon rates consider interest rates. Higher interest rates result in better fixed-income opportunities.