What it means
The coupon rate is fixed at issue and printed into the bond's terms, so the cash payment never changes even though the bond's market price moves daily. That is the single most important thing to understand: the coupon is a fixed dollar amount, while the yield an investor actually earns depends on what they paid for the bond.
For the issuing company or government, the coupon is simply the cost of borrowing. Setting it too low means the bond will not sell at face value, and setting it too high means paying more interest than the market required, so issuers price it against the yields on comparable existing debt.
Most bonds pay semi-annually, so the annual coupon is halved and paid twice a year. Some pay quarterly or annually, and zero-coupon bonds pay nothing at all during their life, instead being issued at a discount and redeemed at full face value.
The relationship between coupon and market price is inverse and mechanical. If interest rates rise after issue, a bond paying a below-market coupon becomes less attractive, so its price falls until the yield an investor earns matches what is available elsewhere.
There are variations worth knowing. Floating rate notes reset their coupon periodically against a reference rate, step-up bonds increase the coupon on set dates, and payment-in-kind notes settle the coupon in more bonds rather than cash, which is a signal about the issuer's cash position.
In practice
Real-world examples.
Example
A city issues $20,000,000 of eight-year bonds with a 5% coupon to fund a water treatment plant. It must budget $1,000,000 a year in interest, paid as $500,000 every six months, regardless of what happens to market rates afterwards. The certainty is precisely why the finance committee preferred a fixed coupon to a floating one.
Example
A pension fund buys corporate bonds with a 6% coupon at a price of $10,500 per $10,000 of face value. Its current yield is $600 / $10,500 = 5.71%, below the coupon rate, because it paid a premium for a bond issued when rates were higher.
Example
A company under cash pressure issues notes with a payment-in-kind coupon, settling interest in additional notes for the first three years. Investors demand a much higher rate in return, and analysts read the structure as a clear signal that near-term cash flow is tight.
Formula
Calculation
Annual coupon payment = face value x coupon rate.
Payment per period = annual coupon payment / number of payments per year.
Current yield = annual coupon payment / current market price.
Take a bond with a face value of $10,000 and a coupon rate of 5%, paying semi-annually with eight years to maturity.
Annual coupon payment = $10,000 x 0.05 = $500.
Each semi-annual payment = $500 / 2 = $250.
Total coupons over the life of the bond = 8 x 2 x $250 = $4,000, on top of the $10,000 face value repaid at maturity.
Now suppose interest rates rise and the bond trades at $9,200. The coupon is unchanged at $500 a year, so the current yield = $500 / $9,200 = 5.43%. A buyer at that price also stands to receive $10,000 at maturity, an $800 gain on top of the coupons, which is why the full yield to maturity is higher still than 5.43%.Case study
Seen in the real world.
The Fennimore Water Authority is a fictional public body created for this illustrative example. It needed $20,000,000 for a treatment plant and issued eight-year bonds with a 5% coupon at face value, committing to $1,000,000 of interest a year, or $500,000 every six months, and $8,000,000 of coupons over the full term.
Eighteen months later market rates rose sharply, and the bonds traded down to about $9,200 per $10,000 of face value. Several board members read this as a loss and asked whether the authority should buy the debt back. The finance officer explained that Fennimore's own cost had not changed at all: it still paid $500 per bond per year and would still repay $10,000 per bond at maturity, and the price fall was simply new buyers repricing an old coupon against today's yields.
The illustrative point is one that catches out a lot of first-time issuers and investors. A coupon is a promise about cash, not a promise about price, and the market value of a bond can move a long way without altering a single payment the issuer actually makes.
Watch out
Common mistakes.
- Treating the coupon rate as the return you will earn. The coupon is fixed against face value, so an investor who pays a premium or a discount earns a yield different from the stated rate.
- Assuming a falling bond price costs the issuer money. The issuer's payments are fixed at issue, and a price change only affects investors buying or selling in the secondary market.
- Forgetting accrued interest when buying between payment dates. The buyer normally pays the seller the interest earned since the last coupon, so the cash outlay is higher than the quoted price suggests.
Questions
People also ask.
What is the difference between the coupon rate and the yield to maturity?
The coupon rate is fixed interest as a percentage of face value, while yield to maturity is the total annual return including any gain or loss between the purchase price and the redemption amount.
Why would anyone buy a zero-coupon bond?
Because it is issued well below face value and redeemed at full value, so the entire return comes as a capital gain, which suits investors matching a known future liability.
Can a coupon be missed?
Yes, and a missed coupon usually counts as an event of default under the bond's terms, which can trigger the whole principal becoming immediately repayable.
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