Forbes: This Business Banking Fintech Crossed $1 Billion in Assets on the Platform

What Is the Coupon Rate of a Bond?

Meow Advisory, LLC

Meow Advisory, LLC

A bond's coupon rate is one of the most basic yet critical numbers for investors to understand. It represents the annual interest payment that a bondholder will receive based on the face value of the bond. Coupon rates drive how attractive or expensive a bond is relative to other income generating investments. As such, assessing a bond's coupon is essential for making informed investment decisions in the fixed income market.

This article provides an in-depth look at how coupon rates work. We'll cover key topics like:

  • Calculating a bond's coupon rate
  • How the coupon rate impacts the price and yield of a bond
  • Differences between the coupon rate and a bond's yield to maturity
  • Factors that influence a bond's coupon rate
  • Alternatives like zero-coupon bonds
  • Investor implications

By the end, you'll understand this fundamental component of bond investing and how to evaluate the coupon rate as part of your analysis.

Calculating the Coupon Rate

A bond's coupon rate represents the annual dollar amount of interest that its issuer will pay to the bondholder. It is expressed as a percentage of the bond's face or par value - the amount that will be repaid when the bond matures.

For example, a bond with a $1,000 face value and a 5% coupon rate will pay $50 per year in interest (5% of $1,000).

The formula to calculate a bond's coupon rate is:

  • Coupon Rate = Annual Coupon Payment / Face Value of the Bond

Or expressed mathematically:

  • C = I / P

Where:

  • C = Coupon rate
  • I = Annual interest or coupon payment
  • P = Par or face value of the bond

For example:

  • A company issues a 5-year bond with a face value of $20,000 and commits to making annual coupon payments of $1,200.

To calculate the coupon rate:

  • Annual Coupon Payment = $1,200
  • Face Value = $20,000
  • Coupon Rate = $1,200 / $20,000 = 0.06 or 6%

So this bond has a coupon rate of 6% paid annually.

How Coupon Rates Affect Bond Pricing

A bond's coupon rate has an inverse relationship to its price in the secondary market once the bond starts trading. Specifically:

  • When prevailing interest rates rise above the fixed coupon rate, the bond's price falls
  • When prevailing rates fall below the coupon rate, the bond's price increases

The reason is that the coupon becomes relatively less attractive when market rates go up - so investors aren't willing to pay full face value to buy the bond. The opposite happens when general rates decline.

For example, say a bond was issued with a 4% coupon when prevailing rates were 4%, and it sold at par value ($1,000). If market interest rates later rise to 6%, then that bond pays less than what investors can get from newly issued bonds. Instead of paying $1,000, investors may only be willing to pay $800 to get a 4% coupon rate.

The bond is said to trade at a discount or below face value. The opposite occurs when market rates fall below the fixed coupon rate, causing the bond price to rise above par value.

Comparing Coupon Rate and Bond Yield

The coupon rate represents the fixed annual payment for a bond, expressed as a percentage of face value.

A bond's yield to maturity is a related but distinct metric. Yield factors in the bond's market price and total return an investor will earn if they hold it to maturity.

Specifically, yield to maturity is the interest rate that makes the present value of future cash flows equal to the market price of the bond. So unlike the coupon rate, a bond's yield metric does change over time if the market price moves up or down.

In summary:

  • Coupon rate stays fixed throughout the bond term
  • Yield fluctuates depending on market pricing
  • When market price = face value, then yield = coupon rate

Factors Influencing Coupon Rates

When a company or government entity first issues bonds, how do they determine the interest rate or coupon to offer investors?

The two primary factors are:

1. Benchmark interest rates

The issuer pegs initial coupon rates to prevailing interest rates for comparable maturity debt at the time of issuance. The goal is to price the bond to attract investor capital by matching other options in the market.

Common rate benchmarks include U.S. Treasury yields, the prime rate, LIBOR, SOFR, etc. If these underlying benchmarks rise or fall over time, newly issued bonds adjust their coupon rates accordingly.

2. Credit risk profile

The likelihood that the issuer defaults on repayment also significantly impacts the coupon rate they need to offer investors.

High credit risk means investors demand a higher yield to compensate for the potential downside. U.S. Treasury bonds are considered virtually default-proof, so they offer the lowest rates. By contrast, speculative grade "junk bonds" from less creditworthy firms must pay top dollar to attract investment.

The bond issuer's financial strength, leverage, profitability and credit ratings all feed into the credit risk assessment. The higher the risk, the higher the required coupon rate at issuance to entice capital from investors.

Alternatives: Zero-Coupon Bonds

Most bonds distribute coupon payments to investors throughout the term until maturity. However, some specialized bonds pay no periodic coupon. These are called zero-coupon bonds.

Instead, zero-coupon bonds trade at a deep discount to face value when issued. The investor receives one payment at maturity equal to the full face amount. The effective yield comes from buying below par and redeeming at par - similar to zero-coupon CDs.

Pros of zero-coupon bonds include not relying on recurring coupon payments and having certainty of fixed returns if held to maturity. However, they tend to be less liquid than coupon bonds. The value also fluctuates more with interest rate changes.

One niche use case is in retirement planning when investors want to lock-in fixed income that begins at a future date, aligning with their projected spending needs.

Key Takeaways

To recap the key points:

  • A bond's coupon rate represents the fixed annual interest payment relative to the face value of the bond
  • Prevailing interest rates and an issuer's credit risk profile primarily dictate coupon rates at issuance
  • When market rates exceed the coupon rate, the bond price falls - and vice versa
  • Yield to maturity differs from coupon rate by factoring in the bond's market price and total return
  • Alternatives like zero-coupon bonds offer no regular coupons but instead deliver face value at maturity

Understanding how coupon rates work provides a building block for fixed income investors. Assessing the coupon is essential for evaluating any bond investment and comparing relative value across different options. Coupon rates also signal expectations for monetary policy and the macro-economic landscape over time.

Brokerage services are provided by Atomic Brokerage, LLC ("Atomic Brokerage"), a registered broker-dealer and member of FINRA and SIPC. Neither Meow Advisory LLC nor Atomic Brokerage are a bank. Investments in securities are Not FDIC insured, Not Bank Guaranteed, and May Lose Value. Investing involves risk, including the possible loss of principal. Before investing, consider your investment objectives and the fees and expenses charged. For more details about Atomic Brokerage, please see the Form CRS, General Disclosures, and the Privacy Policy. Check the background of Atomic Brokerage on FINRA’s BrokerCheck. Custodial and clearing services are provided to Atomic Brokerage by Pershing LLC. Technology services may be provided by AtomicVest.

Get started with Meow

Apply Now

Put your company's idle cash to work

TwitterLinkedIn

Resources

Legal

*Disclaimer: Meow Advisory LLC is a registered investment adviser. Registration as an investment adviser does not imply any level of skill or training.
For accounts opened through Atomic Brokerage LLC: Meow Advisory LLC has an engagement with Atomic Brokerage LLC (“Atomic Brokerage”), a registered broker-dealer and member of FINRA and SIPC , to bring you the opportunity to open a brokerage account. Brokerage services for customers of Meow Advisory LLC are provided by Atomic Brokerage. For more details about Atomic Brokerage, please see the Form CRS, General Disclosures, and the Privacy Policy. Check the background of Atomic Brokerage on FINRA’s BrokerCheck.
For subadvisory services for accounts opened through Atomic Invest LLC: Meow Advisory LLC has an engagement with Atomic Invest, LLC (“Atomic Invest”), an SEC-registered investment adviser, to bring you the opportunity to open an investment advisory account. Investment advisory services are provided by Atomic Invest. Companies which are engaged by Atomic Invest receive compensation of 0% to 0.85% annualized, payable monthly, based upon assets under management for each referred client who establishes an account with Atomic Invest (i.e., exact payment will differ). Atomic Invest also shares a percentage of compensation received from margin interest and free cash interest earned by customers with Meow Advisory LLC. Meow Advisory LLC is not a client of Atomic Invest, but our engagement with Atomic invest gives us an incentive to refer you to Atomic Invest instead of another investment adviser. This conflict of interest affects our ability to provide you with unbiased, objective information about the services of Atomic Invest. This could mean that the services of another investment adviser with whom we are not engaged could be more appropriate for you than Atomic invest. Advisory services through Atomic Invest are designed to assist clients in achieving a favorable outcome in their investment portfolio. They are not intended to provide tax advice or financial planning with respect to every aspect of a client’s financial situation and do not include investments that clients may hold outside of Atomic Invest. For more details about Atomic Invest, please see the Form CRS, Form ADV Part 2A, the Privacy Policy, and other disclosures. Brokerage services for Atomic Invest are provided by Pershing Advisor Solutions LLC (“PAS”), a registered broker-dealer and member of FINRA and SIPC.
Neither Atomic Invest nor Atomic Brokerage, nor any of their affiliates, is a bank. Investments in securities are Not FDIC insured, Not Bank Guaranteed, and May Lose Value. Investing involves risk, including the possible loss of principal. Before investing, consider your investment objectives and the fees and expenses charged by Atomic Brokerage and/or Atomic Invest.
See the Legal Section within the Meow website for additional agreements.

U.K. Gilt pricing quoted net of fees. ~5% U.K. Gilt yield is sourced from Investing.com December 2023 6-month United Kingdom 6-Month Bond Yield. ~5% Treasury Bill yield is sourced from treasurydirect.gov December 2023 12-week U.S. Treasury Bill auction.

**Disclaimer: Meow Technologies is a financial technology company, not a depository, bank or credit union, and your account at Meow is not, itself, an FDIC-insured product.

Meow currently partners with three banking providers. Banking services are provided by Third Coast Bank SSB; Member FDIC, Grasshopper Bank, N.A; Member FDIC, and FirstBank, a Tennessee corporation; Member FDIC.

By opening a Maximum Checking account through Meow and if you choose to receive banking services provided by Grasshopper Bank, N.A, you deposit your funds into a deposit account at Grasshopper Bank, N.A. which sweeps those funds into deposit accounts across a network of Federal Deposit Insurance Corporation (“FDIC”)-insured banks, for up to the current standard maximum deposit insurance amount (“SMDIA”) of $250,000 per eligible depositor, per destination institution, for each ownership capacity or category, subject to applicable terms and conditions, including Grasshopper's ICS Deposit Placement Agreement. Grasshopper Bank, N.A. uses a third-party vendor and agent to help administer this sweep process. Visit https://www.intrafi.com/network-banks/ for a list of the banks and savings associations with which we/Grasshopper, N.A. have a business relationship for the placement of deposits at destination institutions, and into which your deposits may be placed (subject to applicable terms with you, and any opt-outs by Grasshopper, N.A. or you). The current maximum deposit insurance amount for your funds is up to $125 million in FDIC insurance through the sweep network of Grasshopper Bank, N.A, subject to change at any time with notice from Meow and/or pursuant to applicable law. Terms and restrictions apply. Subject to applicable rate sheet. Interest rate on checking products quoted in Annual Percentage Yield (APY). Interest rates and yields are effective as per the date on the applicable rate sheet. See applicable terms and restrictions and refer to the applicable rate sheets for additional information.

By opening a Maximum Checking account through Meow and if you choose to receive banking services provided by Third Coast Bank SSB, you deposit your funds into a deposit account at Third Coast Bank SSB. If you also hold funds in a sweep program with Third Coast Bank SSB, Third Coast Bank SSB sweeps those funds into deposit accounts across a network of FDIC-insured banks, for up to the current SMDIA of $250,000 per eligible depositor, per receiving bank, for each ownership capacity or category, including any other balances you may hold at that receiving bank directly or indirectly through other intermediaries, including broker-dealers. Third Coast Bank SSB uses a third-party vendor and agent to help administer this sweep process. Visit Third Coast Bank SSB for a list of the banks and savings associations with which we/Third Coast Bank SSB have a business relationship for the placement of deposits at receiving banks, and into which your deposits may be placed (subject to applicable terms with you, and any opt-outs by Third Coast Bank or you). The current maximum deposit insurance amount for your funds is up to $50 Million in FDIC insurance through the sweep network of Third Coast Bank, subject to change at any time with notice from Meow and/or pursuant to applicable law. Terms and restrictions apply. Subject to applicable rate sheet. Interest rate on checking products quoted in Annual Percentage Yield (APY). Interest rates and yields are effective as per the date on the applicable rate sheet. See applicable terms and conditions and refer to the applicable rate sheet for additional information.

By opening a Maximum Checking account through Meow and if you choose to receive banking services provided by FirstBank, a Tennessee corporation, you deposit your funds into a deposit account at FirstBank, which sweeps those funds into deposit accounts across a network of FDIC-insured banks, for up to the current SMDIA of $250,000 per eligible depositor, per destination institution, for each ownership capacity or category, subject to applicable terms and conditions, including FirstBank's ICS Deposit Placement Agreement. FirstBank uses a third-party vendor and agent to help administer this sweep process. Visit IntraFi for a list of the banks and savings associations with which FirstBank has a business relationship for the placement of deposits at destination institutions, and into which your deposits may be placed (subject to applicable terms with you, and any opt-outs by FirstBank or you). The current maximum deposit insurance amount for your funds is up to $125 million in FDIC insurance through the sweep network of FirstBank, subject to change at any time with notice from Meow and/or pursuant to applicable law. Terms and restrictions apply. Subject to applicable rate sheet. Interest rate on checking products quoted in Annual Percentage Yield (APY). Interest rates and yields are effective as per the date on the applicable rate sheet. See applicable terms and restrictions and refer to the applicable rate sheet for additional information.

***FDIC insurance coverage is only available to protect you against the failure of an FDIC-insured bank that holds your deposits (and does not protect you against the failure of Meow or other third party). Your account with Meow and all services provided to you are subject to the Meow Terms of Service (“Account Agreements”) and other applicable terms and no other representations or warranties, express or implied, are provided to you except as expressly set forth in those written Account Agreements. If you have any questions regarding your account, please contact team@meow.com.

FirstBank Funds Availability Notice

FirstBank’s general policy is to allow you to withdraw funds deposited in your account on the first business day after the day we receive your deposit. Funds from electronic deposits will be available on the day we receive the deposit. In some cases, we may delay your ability to withdraw funds beyond the first business day. Then, the funds will generally be available by the SECOND business day after the day of deposit.