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All bonds have a coupon interest rate, sometimes referred to as coupon rate or simply coupon, that is the fixed annual interest paid by the issuer to the bondholder. Coupon interest rates are determined as a percentage of the bond's face value but differ from interest rates on other financial products because it is the dollar amount, not the percentage that is fixed over time. 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 drops to $500.It is 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.

For example: 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 have a huge impact on investing, and this is also true with bonds. When the prevailing market rate of interest is higher than the coupon rate, such as interest rates may be at 7% but a bond's coupon is only 5% of face value, the tendency is for the price of the bond to drop on the open market. This is because investors do not want to purchase a bond at face value and receive a 5% yield when they could find 7% elsewhere. This drop in demand pushes down the price of the bond 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.

Conversely, a bond with a higher coupon rate than the market rate of interest tends to raise in price. If the general interest rate is 3% but the coupon is 5%, investors rush to purchase the bond to achieve a higher return on their investment. This increased demand causes bond prices to rise until, other things being equal, the $1,000 face value bond sells for $1,666.In reality, bondholders are just as concerned, if not more, with the bond yield-to-maturity than current yield, as bonds with shorter maturity tend to have smaller discounts or premiums. The credit rating given to bonds also has a large influence on price. It could be very possible that the bond's price does not accurately reflect the relationship between the coupon rate and other interest rates. Things get even more complicated when you start adding in call options. All things being equal, however, the coupon rate affects the price of bonds until the current yield equals prevailing interest rates.

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