DEFINITION of Current Coupon
A current coupon refers to a security that is trading closest to its par value without going over par. A bond has a current coupon status if its coupon is set approximately equal to the bonds' yield to maturity (YTM) at the time of issuance.
BREAKING DOWN Current Coupon
The movement of interest rates in the markets impacts the value of a bond. When interest rates increase, the price of a bond falls, and vice versa. Regardless of the direction of interest rate movements in the economy, the rates on a bond are usually fixed. These fixed rates are referred to as coupon rates, and they determine the interest income a bond holder will receive periodically on his or her fixed income investment. If interest rates rise, new issues will have a higher coupon rate than existing issues. A bond with a coupon close to the yields currently offered on new bonds of a similar maturity and credit risk is known as a current coupon bond.
A current coupon bond is one that is selling at a price close to its par value. The bond has a coupon that is within 0.5% above or below current market rates. Current coupon bonds are typically less volatile than other bonds with lower coupons because the coupon rate is closer to that set by the market. Because a current coupon bond is less volatile, it is also less likely to be called. It has implied call protection rather than an explicit call provision. Its inherent stability, however, also means that it won't offer as great of a return.
The current coupon is mostly used to understand yield spreads of mortgage-backed securities (MBS) which are guaranteed by U.S. government-sponsored enterprises Fannie Mae and Freddie Mac and the government agency Ginnie Mae. As the underlying mortgages of MBSs have different interest rates, various MBSs will have different coupons. In the MBS market, a current coupon is defined as the to-be-announced (TBA) mortgage security of any issue for the current delivery month that is trading closest to, but not exceeding par value. A TBA qualification means that the pool of mortgages that will back the security has not been assigned, even though the contract is about to be made. A synthetic 30-year fixed-rate MBS in the TBA market is the current coupon used as a benchmark throughout the industry to price and value mortgages.
To determine which security is the current coupon, it is necessary to know the par value of the mortgages, which is the sum of the outstanding principals on the underlying mortgages. The current coupon is calculated by interpolating the highest coupon below par and the lowest coupon above par, adjusting for the delay days associated with the securities in question. Alternatively, it is obtained by extrapolating from the lowest coupon above par in case no coupon is trading below par. For example, TBA mortgage securities often trade with interest rates in increments of 0.5%. Therefore, assuming a par value of 100, if Fannie Mae 8% mortgage securities are trading at 99.5 and Fannie Mae 8.5% mortgage securities are trading at 100.75, Fannie Mae's 8% security would be the current coupon.
A principle of mortgage analysis is that the higher a mortgage-backed security's coupon is relative to the current coupon, the more likely that mortgage-backed security is to prepay. Mortgage investors make this relative value analysis in calculating MBS yields and valuations. In addition, the current coupon reflects the state of the mortgage market; thus, lenders and borrowers can use it as an indicator of what the fair rate for new mortgages should be.