What Is The Coupon Rate Of A Bond?
Coupon Rate is mostly applied to bonds and it is usually the ROI (rate of interest) that is paid on the face value of a bond by the issuers of bond and it is also used to calculate the repayment amount that is made by GIS (guaranteed income security).
It is given by the issuer to the bondholder which is a particular percentage of the bond’s face value and represents a regular income paid to the investor. It is usually paid annually or semi-annually and is determined at the time of issue. It is used to calculate the yield to maturity or the return of the bond.
Table of contents
- The “coupon rate” is most commonly used in bonds. Typically, the ROI (interest rate) is paid on the bond’s face value by its issuers and is also used to determine how much a GIS (guaranteed income security) must return.
- To determine a bond’s coupon rate, divide the total yearly payments by the bond’s par value and add 100%. This percentage represents the bond’s annual interest payment based on its face or par value.
- If the coupon rate is less than the market interest rate, the bond is said to be exchanged at a discount and sold at a premium.
Coupon Rate Of A Bond Explained
The coupon of a bond is the interest rate that the bondholder receives from the bond issuer and represents a percentage of the bond’s face value. It helps calculate the regular interest payment that the issuer will pay until the bond matures.
It is typically an annual rate of interest. But while paying to the bondholder, it is done either semi-annually or annually. The rate is fixed at the time of issuance, and it remains fixed throughout the life of the bond. The indenture of the bond is a legally binding agreement which clearly states this interest rate.
This rate is an essential factor contributing to the bond’s yield calculation. Yield is the return that the investor or the bondholders can expect if they hold the bond till maturity. When the coupon rises or falls, it may be higher or lower than the market interest rates, thus impacting the prices.
The coupon rate of a bond can be calculated using the coupon rate of a bond formula by dividing the sum of the annual coupon payments by the par value of the bond and multiplied by 100%. Therefore, the rate of a bond can also be seen as the amount of interest paid per year as a percentage of the face value or par value of the bond. Mathematically, it is represented as,
The bond price varies based on the coupon rate and the prevailing market rate of interest. If the coupon rate is lower than the market interest rate, then the bond is said to be traded at a discount, while the bond is said to be traded at a premium if the coupon rate is higher than the market interest rate. Nevertheless, the bond is said to be traded at par if the coupon rate is equal to the market interest rate
How To Calculate?
The steps to calculate the coupon using the using the coupon rate of a bond formula are the following:
- Firstly, the face value or par value of the bond issuance is determined as per the funding requirement of the company.
- Now, the number of interest paid during the year is determined, and then the annualized interest payment is calculated by adding up all the payments during the year.
Annual interest payment = Periodic interest payment * No. of payments in a year.
- Finally, the formula of the coupon rate of the bond is calculated by dividing the annualized interest payments by the par value of the bond and multiplied by 100%, as shown below.
Let us try to explain the concept with the help of a suitable example.
Let us take the example of a bond with quarterly coupon payments. Let us assume a company XYZ Ltd has issued a bond having a face value of $1,000 and quarterly interest payments of $15.
- If the prevailing market rate of interest is 7%, then the bond will be traded at _______
- If the prevailing market rate of interest is 6%, then the bond will be traded at _______
- If the prevailing market rate of interest is 5%, then the bond will be traded at _______
As per the given question,
Par value of bond = $1,000
Annual interest payment = 4 * Quarterly interest payment
- = 4 * $15
- = $60
Therefore, let us find the coupon rate of a bond which can be calculated using the above formula as,
- Since the coupon (6%) is lower than the market interest (7%), the bond will be traded at a discountBond Will Be Traded At A DiscountA discount bond is one that is issued for less than its face value. It also refers to bonds whose coupon rates are lower than the market interest rate and thus trade for less than their face value in the secondary market..
- Since the coupon (6%) is equal to the market interest (7%), the bond will be traded at par.
- Since the coupon (6%) is higher than the market interest (5%), the bond will be traded at a premium.
When a bond is issued in the open market by a company, it arrives at the optimal coupon rate based on the prevailing rate of interest in the market to make it competitive.
Also, the issuer’s creditworthiness drives the coupon rate of a bond, i.e., a company rated “B” or below by any of the top rating agencies is likely to offer a higher coupon rate than the prevailing market interest rate to counterbalance the additional credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. taken by the investors.
In short, the coupon rate is influenced by the market interest rates and the issuer’s creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan..
Relevance And Uses
Coupon Rate is referred to the stated rate of interest on fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments. securities such as bonds. In other words, it is the rate of interest that the bond issuersThe Bond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures. pay to the bondholders for their investment. It is the periodic rate of interest paid on the bond’s face value to its purchasers. It is to be noted that the coupon rate is calculated based on the bond’s face value or par value, but not based on the issue price or market value.
It is quintessential to grasp the concept of the rate and find the coupon rate of a bond because almost all types of bonds pay annual interest to the bondholder, known as the coupon rate. Unlike other financial metrics, the coupon payment in terms of the dollar is fixed over the bond’s life. For example, if a bond with a face value of $1,000 offers a coupon rate of 5%, then the bond will pay $50 to the bondholder until its maturity. The annual interest payment will remain $50 for the entire bond life until its maturity date, irrespective of the rise or fall in the bond’s market value.
Another important facet of the rate is that if the prevailing market interest rate is higher than the rate of the bond, then the price of the bond is expected to fall because an investor will be reluctant to purchase the bond at that face value now, as they can get a better rate of return elsewhere. On the other hand, if the prevailing market interest rate is lower than the coupon rate of the bond, then the price of the bond is expected to increase because it will pay a higher return on investment than an investor can make by purchasing a similar bond now, as the coupon rate will be lower resulting in the in an overall decline in interest rates.
Coupon Rate Vs Bond Yield
Both the above concepts are two important measures that can be related to bon issues. However, there are some differences between them. Let us find out the important differences.
- The former represents an annual fixed interest rate which is expressed as a percentage of the face value of a bond, whereas the latter represents that return that an investor can hope to earn if they hold the bond till maturity.
- The former the interest payment that the issuer pays to the bondholder till maturity whereas the latter takes in to consideration both the coupon and any capital gain or loss if the bond is purchased or sold at a price which is different from its face value.
- The former is determined when the issuer issued the bond, whereas the latter is determined during the tenure of the bond.
- If the bond is priced at par value, that is equal to the face value, both coupon and yield will be equal to each other.
- If the bond is priced at a premium, the yield will be lower than the interest rate or coupon of the bond.
- If the investor buys the bond at discount, that is less than the face value, the effective yield will be higher than the coupon.
Thus, the above are some important differences between the coupon and the yield of a bond.
Frequently Asked Questions (FAQs)
A bond’s face or par value may alter, but its coupon rate is fixed. The interest payments on the bond will always be $20 annually, regardless of the market price.
The coupon rate chosen by a bond issuer is determined, among other things, by current market interest rates at the time of issuance. Market interest rates fluctuate throughout time, and when they do, the bond’s value rises or falls depending on whether they are lower or greater than the coupon rate.
When choosing the coupon rate for a bond, the issuer considers the current market interest rates and other factors. The value of a bond rises or falls depending on whether market interest rates are lower or higher than the coupon rate on the bond.
This has been a guide to what is Coupon Rate of a Bond and its definition. Here we discuss how to calculate Coupon Rate along with its formula, examples, and relevance. You can learn more about from the following articles –