How to calculate the coupon rate of a bond?

The coupon rate (also called nominal yield) is the annual coupon payments paid by the bond issuer relative to the bond's face or par value. The formula to calculate the coupon rate of a bond is:

Coupon Rate = (Annual Coupon Payment / Face Value of Bond) * 100

Let's say you want to buy a Rs 1,000 bond that pays Rs 40 in interest every year. The coupon rate would be 4 (40/1000 * 100).

Example of a coupon rate

The coupon rate is stated in terms of a bond's annual interest payment as a percentage of its face value. For example, if you buy a bond that has a face value of Rs 1,000 and pays Rs 60 per year in interest, the coupon rate is 6%.

For most bonds, the coupon rate is set at issuance (in other words, when it was first sold to investors) and is fixed throughout the life of the bond. However, some bonds are issued with floating or variable rates where the issuer can adjust the coupon payments at their discretion. Some companies issue bonds with this feature to help them manage interest expense risk.

In any given issue of bonds from one company—as opposed to different issues from different companies—all of the bonds will have the same coupon rate.

If the coupon rate is higher, the returns an investor generates from holding the bond will also be higher.

For example, a bond with a coupon rate of 5% pays Rs 50 (Rs 1,000 * .05) in interest payments every year for ten years. Because its annual coupon rate is 5%, it will also be worth more than a similar bond with a 3% coupon rate that only pays Rs 30 in interest payments per year (Rs 1,000 * .03). The reason is simple: all else being equal, if you bought two bonds and one was paying you more money each year than the other, then you would prefer to own the one that paid you more annually.

Remember that there is an inverse relationship between the price and yield of a bond. If an investor pays out more money for a bond (i.e., buys it at an above face value), its return falls (i.e., its yield falls); if an investor pays out less money for a bond (i.e., buys it at below face value), its return rises (i.e., its yield rises).

Drivers of a coupon rate of a bond

The coupon rate is determined by the investor’s risk appetite. Higher-risk investments, such as junk bonds or emerging market debt, will have higher coupon rates than low-risk investments like short-term treasury bills. The bond's rating (which measures the creditworthiness of the issuer) and its term are two factors that determine the level of risk investors take on when buying bonds, in addition to several other factors.

If a bond is considered high risk, it will typically have a higher coupon rate than a lower-risk investment. Investors want to be compensated for taking on more risk and so they ask for higher interest rates.

However, remember that ultra-safe government bonds also have very low coupon rates due to their minimal risk factors - they won't default because governments can easily print money to repay investors, so there is virtually no chance of losing principal.