What is a Coupon Rate?

The Relationship Between Bonds and Interest Rates

Contents:

The Difference Between a Bond's Yield Rate and Its Coupon Rate

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 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 higher or lower 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.

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An equally undesirable alternative is selling the bond for less than its face value at a loss. 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.

Thus, bonds with higher coupon rates provide a margin of safety against rising market interest rates. 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.

Coupon (bond)

Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost. Investors constantly compare the returns on their current investments to what they could get elsewhere in the market.

As market interest rates change, a bond's coupon rate—which, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let's look at an example. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: What if rates go up?

The Difference Between a Bond's Yield Rate and Its Coupon Rate

Now let's suppose that later that year, interest rates in general go up. What if rates fall? It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market. Of course, many other factors go into determining the attractiveness of a particular bond: But the important thing to remember is that change occurs in market interest rates virtually every day. The movement of bond prices and bond yields is simply a reaction to that change.

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