The coupon rate is the interest rate that is paid on a bond (normally paid on a semiannual basis) that is stated when the bond is issued until it reaches maturity. Bonds are types of debts or IOUs that companies, municipalities or governments sell and people buy.
The coupons rate is equal to the annual coupon payments paid by an issuer that is relevant to the face or par value of a bond.
It is essentially the yield that a bond pays on its issue date. However, the yield can vary according to changes in the value of a bond in the time it takes to reach maturity.
Coupon payments are represented as a percentage of the face value (par) of a bond. Face value is the price at which it was issued.
Video explanation of what the coupon rate is
1922 Mecca Temple (NY, USA) bond coupons. (Image: Wikipedia)
It is called a ‘coupon’ because in the past, bonds literally used to have coupons attached to them. Bond-holders would collect their interest by taking off the coupons and cashing them in – this was known as ‘clipping the coupon’. As most bonds are recorded electronically today, physical coupons are much less common.
According to Cambridge Dictionaries Online, the coupon rate is “the rate of interest that is paid on a bond.”
Example of of a coupon payment and the use of the coupon rate:
Assume that a bond has a par value of $5,000 and a coupon rate of 5%. This would make total annual coupon payments equal to $250. For the typical bond, this will be made up of semi-annual payments of $125.
Overall, investors tend to prefer bonds with higher coupon rates.
Not every bond has a coupon. In fact, zero-coupon bonds (also known as discount bonds) pay no coupons and have a coupon rate of 0%. These types of bonds only make the payment of the face value on the maturity date, and are bought at a lower price than their face value.
Coupon rate versus yield
The bond’s coupon rate is how much income it brings in in interest each year, based on its face value.
Its yield to maturity is an estimate on how much the return will be, assuming it is held until it matures (if it is not cashed in or traded earlier).
A yield to maturity calculation factors in the coupon rate. For an investor, a bond’s yield to maturity matters more than its coupon rate.
Imagine you buy a bond with a face value of $1,000, and you receive two $25 interest payments each. That bond’s coupon rate is the percentage you receive in one year – you receive $50, which is $5% of $1,000. So, youR bond has a coupon rate of 5%. The coupons never change, regardless of what price the bond trades for, you will always get $50 per year.
If you sell your bond at a $200 premium, its yield is now equal to 4.16% ($50 ÷ $1,200 x 100 = 4.16%).
Yield to maturity tells you what your average return will be over the remaining term of the bond.
Video – Coupon, Yield & Expected Return