What Is the Coupon Rate of a Bond?

By Rebecca Lake · January 04, 2022 · 7 minute read

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What Is the Coupon Rate of a Bond?

A coupon rate is the nominal interest rate or yield associated with a fixed-income security. A bond coupon rate represents the annual interest rate paid on a bond by the issuer, as determined by the bond’s face value. Issuers typically pay bond coupon rates on a semiannual basis.

The coupon rate of a bond can tell an investor how much interest they can expect to collect on a yearly basis via coupon payments. The bond coupon rate is not the same as the bond yield, which investors use to estimate the total rate of return.

Investment-quality bonds can help with diversification in a portfolio while providing a consistent stream of interest income. Understanding coupon rate and what it means is important when choosing bonds in which to invest.

What Is Coupon Rate?

Coupon rate is a predetermined percentage of interest, typically paid out twice per year. Investors often use the term “coupon rate” when discussing fixed-income securities, including bonds and notes.

Bonds represent a debt, wherein the bond issuer agrees to periodically pay interest to investors who purchase the bonds in exchange for the temporary use of their capital. Investors can buy individual bonds, bond funds or bond options, which are similar to stock options.

The coupon rates for their bonds reflect on the bond’s par or face value at issuance. This means the rate won’t change for the maturity of the bond. The coupon interest rate tells you what percentage of the bond’s face value you’ll receive yearly. Coupon rates are typically lower for investment-grade bonds and higher for junk bonds, due to their higher risk.

So, assume you purchase a bond with a face value of $1,000. The bond has a coupon rate of 4%. This means that for each year you hold the bond until maturity, you’d receive $40, regardless of what you paid for the bond.

Coupon Rate Formula

The bond coupon rate formula is fairly simple and it looks like this:

Bond coupon rate = Total annual coupon payment/Face or par value of the bond x 100

To apply the coupon rate formula you’d need to know the face or par value of the issued securities and the total interest payment. To find the annual coupon payment, you’d multiply the amount of interest paid by the number of periodic payments made for the year. You’d then divide that by the par value and divide the result by 100.

How to Calculate Coupon Rate (Example)

Say you have a bond with a face value of $1,000. That bond pays $25 in interest to you twice per year. To find the annual coupon payment you’d simply multiply $25 by two to get $50. You’d then divide the $50 annual coupon payment by the $1,000 par value of the bond and multiply by 100 to find that your bond has a coupon rate of 5%.

How Does Coupon Rate Affect Bond Price?

Bond prices can move up or down based on its coupon rate, relative to movements in interest rates. When interest rates are higher than the bond’s coupon rate, that bond’s price may fall in order to offset a less attractive yield. If interest rates drop below the bond’s coupon rate, the bond’s price may rise if it becomes a more attractive investment opportunity.

When comparing coupon rates and bond prices, it’s important to understand the relationship between the bond’s face value and what it trades for on the secondary market. If a bond is trading at a price above its face value, that means it’s trading at a premium to par. Conversely, if a bond is trading at a price below its face value, that means it’s trading at a discount to par.

An investor who purchases a bond with the intent to hold it until it reaches maturity does not need to worry about bond price movements. Their end goal is to collect the annual interest payments and recover their principal on the assigned maturity date, making it a relatively safe investment as long as the issuer fulfills their obligation.

Investors looking to buy bonds and resell them before they mature, however, may pay attention to which way bond prices are moving relative to the coupon rate to determine whether selling would yield a profit or loss.

Coupon Rate Comparisons

Coupon rate tells investors how much interest a bond will pay yearly until maturity. But there are other metrics for evaluating bonds, including yield to maturity and interest rates. Understanding the differences in what they measure matters when determining whether bond investments are a good fit and what rate of return to expect.

Coupon Rate vs Yield to Maturity

Yield to maturity or current yield reflects the interest rate earned by an investor who purchases a bond at market price and holds on to it until it reaches maturity. A bond’s maturity date represents the date at which the bond issuer agrees to repay the investor’s principal investment. Longer maturity dates may present greater risk, as they leave more room for the bond issuer to run into complications that could make it difficult to repay the principal.

When evaluating yield to maturity of a bond, you’re looking at the discount rate at which the sum of all future cash flows is equal to the price of the bond. Yield to maturity can be quoted as an annual rate that’s different from the bond coupon rate. In figuring yield to maturity, there’s an assumption that the bond issuer will make coupon and principal payments to investors on time.

The coupon rate is the annual interest earned while yield to maturity reflects the total rate of return produced by the bond when all interest and principal payments are made.

Yield-to-Maturity Formula

To find yield to maturity for a single bond, you’d apply this formula:

Yield to maturity = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]

So you’d subtract the bond’s current market price from its face value, divide that number by the maturity term and add in the annual interest. You’d then divide that figure by half of the bond’s face value plus its price.

Coupon Rate vs Interest Rate

Interest rates can influence coupon rates. The coupon rate of a bond is the rate of interest paid annually, based on the bond’s face value. Again, the issuer – typically a company or government entity – determines the bond coupon rate at issuance and it does not change.

An interest rate, meanwhile, represents the rate a lender charges a borrower. Individual lenders determine interest rates, often based on movements in an underlying benchmark rate. When discussing bond coupon rates and interest rates, it’s typically in the context of changes to the federal funds rate. This is the rate at which commercial banks lend to one another overnight.

Movements in the federal funds rate can influence interest rates, including coupon rates. When interest rates rise, based on changes to the federal funds rate, that can cause bond prices to fall. When interest rates decline, based on changes to the federal funds rate, bond prices typically rise.

Zero-Coupon Bond Alternative

Some bonds, called zero-coupon bonds, don’t pay interest at all during the life of the bond. The upside of choosing zero bonds is that by forgoing annual interest payments, it’s possible to purchase the bonds at a deep discount to par value. This means that when the bond matures, the issuer pays the investor more than the purchase price.

Zero coupon bonds typically have longer maturity dates, which may make them suitable when investing for long-term goals. This type of bond may experience more price fluctuations compared to other types of bonds sold on the secondary market. Investors may still have to pay taxes on the imputed interest generated by the bond, though it’s possible to avoid that by investing in zero coupon municipal bonds or other tax-exempt zero coupon bond options.

The Takeaway

Investing in bonds can help you create a well-rounded portfolio alongside stocks, exchange-traded funds (ETFs) and other securities. As you get closer to retirement, bonds can be an important part of your income and risk management strategy, whether you’re investing through an IRA, a 401(k), or a brokerage account.

The sooner you get started with investing the better, as the power of time and compounding interest are both on your side. A great way to get started is by opening an online brokerage account on the SoFi Invest investment app, which allows you to begin building a portfolio with ease via your phone.

Photo credit: iStock/Inside Creative House

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