There are two major reasons coupon rates vary: changes in market interest rates and the creditworthiness of the issuer. Newly issued bonds tend to provide competitive coupons, meaning many bond coupons issue at or near prevailing rates. Bond issuers with lower credit ratings need to offer even higher coupons to compensate investors for assuming additional risk. Other, less-significant factors include repayment provisions on the bond, the possibility of conversion, callability and general market conditions when issued.

Role of Coupon Rates

"Coupon" is a term that originated when bondholders had to detach and mail in coupons to receive their interest payments. The name stuck even after information began transmitting electronically. Coupons provide payments to the bondholder during the duration of the bond until the maturity date. They are the form of return that bondholders receive and are usually paid in annual or semi-annual installments. An investor is willing to loan money to a bond issuer because he receives coupon payments. Generally speaking, longer-duration bonds pay higher coupons than shorter-duration bonds.

Prevailing Interest Rates

Bond issuers use coupon rates to entice investors. To accomplish this, the issued coupon rate needs to be near the prevailing market interest rate for any given maturity. If the company offers too low a coupon rate, investors are not willing to pay face value for the bond.

To illustrate, suppose 10-year certificates of deposit, or CDs, are offering 6% interest. If an issuing company only offers 4% on its new 10-year bonds, it does not make any sense for investors to forgo the CDs in favor of bonds, particularly because CDs carry FDIC protection.

Instead, the bond issuer is likely to have to offer something above the interest rate paid on safer investments. Perhaps the issues should be at 6.25% instead of 4%. During the bond's lifetime, its value on the secondary market continues to fluctuate in accordance with prevailing interest rates; this occurs until the bond's current yield equals prevailing rates.

Issuer Creditworthiness

All corporate bonds come with investment risks. The prices of bonds fluctuate based on general market conditions, limiting the profitable liquidity in the secondary market. More importantly, there is no guarantee bond issuers will repay their debt investors.

Other than U.S. Treasurys, all securities carry a premium rate of return based on the level of risk investors have to assume when making a purchase. A bond with a relatively high credit rating from an issuer with solid fundamentals does not need to offer much risk premium. A junk bond issuer, on the other hand, needs to offer a coupon rate high enough to attract investors away from other, more secure instruments. This is why junk bonds are often referred to as "high-yield bonds;" the high yield is a form of compensation for extra default risk.

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  2. How does the money from the interest on my bond get to me?

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  3. What is the difference between yield to maturity and the coupon rate?

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  4. What are the key factors that will cause a bond to trade as a premium bond?

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