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Coupon Rate
Coupon Rate
KEY TAKEAWAYS
A bond's coupon rate can be calculated by dividing the sum of the security's annual
coupon payments and dividing them by the bond's par value. For example, a bond
issued with a face value of $1,000 that pays a $25 coupon semiannually has a coupon
rate of 5%. All else held equal, bonds with higher coupon rates are more desirable for
investors than those with lower coupon rates.
The coupon rate is the interest rate paid on a bond by its issuer for the term of the
security. The term "coupon" is derived from the historical use of actual coupons for
periodic interest payment collections. Once set at the issuance date, a bond's coupon
rate remains unchanged and holders of the bond receive fixed interest payments at a
predetermined time or frequency.
A bond issuer decides on the coupon rate based on prevalent market interest rates,
among others, at the time of the issuance. Market interest rates change over time and
as they move lower or higher than a bond's coupon rate, the value of the bond
increases or decreases, respectively.
Changing market interest rates affect bond investment results. Since a bond's coupon
rate is fixed all through the bond's maturity, a bondholder is stuck with receiving
comparably lower interest payments when the market is offering a higher interest rate.
An equally undesirable alternative is selling the bond for less than its face value at a
loss. Thus, bonds with higher coupon rates provide a margin of safety against rising
market interest rates.
If the market rate turns lower than a bond's coupon rate, holding the bond is
advantageous, as other investors may want to pay more than the face value for
the bond's comparably higher coupon rate.
Special Considerations
When investors buy a bond initially at face value and then hold the bond to maturity,
the interest they earn on the bond is based on the coupon rate set forth at the
issuance. For investors acquiring the bond on the secondary market, depending on the
prices they pay, the return they earn from the bond's interest payments may be higher
or lower than the bond's coupon rate. This is the effective return called yield to maturity
(YTM).
For example, a bond with a par value of $100 but traded at $90 gives the buyer a yield
to maturity higher than the coupon rate. Conversely, a bond with a par value of $100
but traded at $110 gives the buyer a yield to maturity lower than the coupon rate.