Coupon rate

Definition

The coupon rate is the interest rate that a bond issuer agrees to pay bondholders, typically expressed as a percentage of the bond's face value. This rate determines the periodic interest payments, known as coupons, that the bondholder will receive until maturity. A bond's coupon rate is an essential factor in assessing its attractiveness and yield compared to other investment options.

5 Must Know Facts For Your Next Test

1. The coupon rate is fixed at the time the bond is issued and remains constant throughout the bond's life.
2. Higher coupon rates generally attract more investors since they provide greater periodic income.
3. If market interest rates rise above a bond's coupon rate, the bond may trade at a discount in the secondary market.
4. Bonds with lower credit ratings often have higher coupon rates to compensate investors for increased risk.
5. The total income from a bond includes both the coupon payments and any capital gains or losses when sold before maturity.

Review Questions

• How does the coupon rate influence investor decisions when purchasing bonds?
  • The coupon rate plays a significant role in investor decisions as it determines the income generated from holding the bond. Investors often compare a bond's coupon rate to prevailing market rates; if it is higher, they may find it more attractive. Conversely, if the market offers better returns elsewhere, a lower coupon rate could deter potential buyers. Thus, understanding the relationship between coupon rates and market conditions is key for making informed investment choices.
• Discuss how changes in market interest rates impact bonds with fixed coupon rates.
  • When market interest rates rise, bonds with fixed coupon rates become less attractive because new bonds may be issued at higher rates. This can lead to existing bonds trading at a discount in the secondary market, as investors seek better yields. On the other hand, if market interest rates fall, existing bonds with higher coupon rates can increase in value, making them more appealing. Therefore, fluctuations in market interest rates directly influence how bonds are valued and traded.
• Evaluate how an investor can use the coupon rate and yield to maturity to assess the overall return of a bond investment.
  • An investor can use both the coupon rate and yield to maturity (YTM) to comprehensively evaluate a bond's potential return. The coupon rate provides insight into regular income received from the bond, while YTM accounts for total returns including interest payments and any gains or losses incurred when selling before maturity. By comparing the two, an investor can determine whether a bond meets their income requirements and risk tolerance. A discrepancy between these figures may indicate that the bond is overvalued or undervalued based on current market conditions.

Related terms

Yield to Maturity:

The total return anticipated on a bond if held until it matures, accounting for all interest payments and any difference between the purchase price and face value.

Face Value: The nominal value of a bond, which is the amount paid back to the bondholder at maturity, usually set at $1,000 for corporate bonds.

Market Interest Rate: The prevailing rate of interest that borrowers pay and lenders receive in the market, which can affect a bond's pricing and yield.