This article will discuss coupon rates in detail. We will look at bond coupons, how they affect investors, and more.
Definition and Examples of a Coupon Rate
The coupon rate of a bond or other fixed income security is the interest rate paid out on the bond. When the government or a company issues a bond, the rate is fixed. The coupon rate is stated as an annual percentage rate based on the bond’s par, or face value. The dollar amount represented by this coupon rate is paid each year—usually on a semiannual basis—to the bondholder until the bond is redeemed at maturity.
How Coupon Rates Work
A coupon rate is the annual amount of interest paid by the bond stated in dollars, divided by the par or face value. For example, a bond that pays $30 in annual interest with a par value of $1,000 would have a coupon rate of 3%. Another type of bond is a zero coupon bond, which does not pay interest during the time the bond is outstanding. Rather, zero coupon bonds are sold at a discount to their value at maturity. Maturity dates on zero coupon bonds tend to be long term, often not maturing for 10, 15, or more years. Though zero coupon bonds do not pay any interest, by looking at what you paid for it, the maturity value, and the duration of the bond, you can reverse engineer the equivalent of an annual interest rate. This is a classic case of discounted cash flow. In other words, you discover the return on a dollar invested today with a promise to receive a higher amount at a specified time in the future. Let’s take a look at an example: A zero coupon bond that costs you close to $3,500 and will pay you $10,000 at maturity in 20 years gives you the benefit equivalent to earning a 5.4% annualized return. Because zero coupon bonds are sold at a discount and pay no interest during the time they are outstanding, their prices tend to fluctuate more than bonds that are sold at their par value and pay interest each year.
Coupon Rate Formula
The formula to calculate a bond’s coupon rate is very straightforward, as detailed below. The annual interest paid divided by bond par value equals the coupon rate. As an example, let’s say the XYZ corporation issues a 20-year bond with a par value of $1,000 and a 3% coupon rate. Bondholders will receive $30 in interest payments each year, generally paid on a semiannual basis. If prevailing interest rates on other similar bonds rise, pushing down the price of the bond in the secondary market, the amount of interest paid remains at the coupon rate based on the bond’s par value. The same will occur if interest rates drop, pushing the price of the bond higher in the secondary market.
Coupon Rate vs. Yield
In contrast to the bond’s coupon rate, which is a stated interest rate based on the bond’s par value, the current yield is a measurement of the dollar amount of interest paid on the bond compared to the price at which the investor purchased the bond. In other words, the current yield is the coupon rate times the current price of the bond. The current yield of a bond is the rate of return the bond generates. For example: ABC bond’s coupon rate was 3%, based on a par value of $1,000 for the bond. This translates to $30 of interest paid each year. Let’s say Investor 1 purchases the bond for $900 in the secondary market but still receives the same $30 in interest. This translates to a current yield of 3.33%. Investor 2 purchases the bond after a decline in interest rates for $1,100. They receive the same $30 in annual interest payments. This translates to a current yield of 2.73%.
What It Means for Individual Investors
A bond’s coupon rate tells an investor the dollar amount of interest they can expect to receive each year for as long as they hold the bond. This can help in planning your cash flow over the period until the bond matures. The bond’s coupon rate can also help an investor determine the bond’s yield if they are purchasing the bond on the secondary market. The fixed dollar amount of interest can be used to determine the bond’s current yield, which will help show if this is a good investment for them. The coupon rate can also be used to benchmark a bond against other income-producing investments an investor may be considering, such as CDs, dividend-paying stocks, or others. Investors considering investing in bonds should consider consulting with a qualified financial advisor to help them understand coupon rates, yields, and what type of bonds make the most sense for their portfolio, given their financial situation and goals.
