Coupon interest rates are determined as a percentage of the bond's par value, also known as the "face value."
Why National Interest Rates Matter
Coupon rates are largely influenced by national government-controlled interest rates. This means that if the minimum interest rate is set at 5%, no new bonds may be issued with coupon rates below this level. However, pre-existing bonds with coupon rates higher or lower than 5% may still be bought and sold on the secondary market.
Most bonds have fixed coupon rates, meaning that no matter what the national interest rate may be—and regardless of marker fluctuation—the annual coupon payments remain static. When new bonds are issued with higher interest rates, they are automatically more valuable to investors, because they pay more interest per year, compared to pre-existing bonds. Given the choice between two $1,000 bonds selling at the same price, where one pays 5% and the other pays 4%, the former is clearly the wiser option.
How Does A Bond’s Coupon Interest Rate Affect Its Price?
Coupon Interest Rate vs. Yield
For instance, a bond with a $1,000 face value and a 5% coupon rate is going to pay $50 in interest, even if the bond price climbs to $2,000, or conversely drops to $500. It is thus crucial to understand the difference between a bond's coupon interest rate and its yield. The yield represents the effective interest rate on the bond, determined by the relationship between the coupon rate and the current price. Coupon rates are fixed, but yields are not.
Another example would be that a $1,000 face value bond has a coupon interest rate of 5%. No matter what happens to the bond's price, the bondholder receives $50 that year from the issuer. However, if the bond price climbs from $1,000 to $1,500, the effective yield on that bond changes from 5% to 3.33%. If the bond price falls to $750, the effective yield is 6.67%.
General interest rates substantially impact stock investments. But this is no less true with bonds. When the prevailing market rate of interest is higher than the coupon rate—say there's a 7% interest rate and a bond coupon rate of just a 5% face value—the price of the bond tends to drop on the open market because investors don't want to purchase a bond at face value and receive a 5% yield, when they could source other investments that yield 7%.
This drop in demand depresses the bond price towards an equilibrium 7% yield, which is roughly $715, in the case of a $1,000 face value bond. At $715, the bond's yield is competitive.
- A bond's coupon interest rate indicates the annual interest paid by issuers to bondholders.
- Coupon interest rates are calculated as a percentage of the bond's par value, which is frequently called its "face value".
- The majority of bonds boast fixed coupon rates, that remain stable, regardless of the national interest rate or changes in the economic climate.
Higher Coupon Rates
Conversely, a bond with a coupon rate that's higher than the market rate of interest tends to raise the price. If the general interest rate is 3% but the coupon is 5%, investors rush to purchase the bond, in order to snag a higher investment return. This increased demand causes bond prices to rise until the $1,000 face value bond sells for $1,666.
The credit rating given to bonds also largely influences the price. It's possible that the bond's price does not accurately reflect the relationship between the coupon rate and other interest rates.
Because each bond returns its full par value to the bondholder upon maturity, investors can increase bonds' total yield by purchasing them at a below-par price, known as a discount. A $1,000 bond purchased for $800 generates coupon payments each year, but also yields a $200 profit upon maturity, unlike a bond purchased at par.