What Is a Coupon Rate?
A coupon rate is the nominal yield paid by a fixed-income security. It is the annual coupon payments paid by the issuer relative to the bond's face or par value.
- A coupon rate is the nominal yield paid by a fixed-income security.
- When a market ticks up and is more favorable, the coupon holder will yield less than the prevailing market conditions as the bond will not pay more, as its value was determined at issuance.
- The yield to maturity is when a bond is purchased on the secondary market, and it's the difference in the bond's interest payments, which may be higher or lower than the bond's coupon rate when it was issued.
Understanding Coupon Rates
The coupon rate, or coupon payment, is the nominal yield the bond is stated to pay on its issue date. This yield changes as the value of the bond changes, thus giving the bond's yield to maturity (YTM).
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.
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.
How Are Coupon Rates Affected by Market Interest Rates?
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. Since a bond's coupon rate is fixed all through the bond's maturity, bonds with higher coupon rates provide a margin of safety against rising market interest rates.
What's the Difference Between Coupon Rate and YTM?
The coupon rate is the annual income an investor can expect to receive while holding a particular bond. It is fixed when the bond is issued and is calculated by dividing the sum of the annual coupon payments by the par value. At the time it is purchased, a bond's yield to maturity and its coupon rate are the same. The yield to maturity (YTM) is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments and will vary depending on its market value and how many payments remain to be made.
What Is the Effective Yield?
The effective yield is the return on a bond that has its coupon payments reinvested at the same rate by the bondholder. It is the total yield an investor receives, in contrast to the nominal yield—which is the coupon rate. Essentially, effective yield takes into account the power of compounding on investment returns, while nominal yield does not.