What is the Coupon Rate?
Fixed-income securities are an asset class that investors consider for investment. The key benefit of this investment avenue is the guaranteed returns and secured principal. Bonds are one such fixed-income security. One of the important features of a bond is the coupon rate, which investors look into before investing.
This article will guide you on coupon rates meaning, what are zero-coupon bonds and how are coupon rates determined.
A coupon rate is the rate of interest paid on the face value of a bond, by the issuer, to the bondholder. For instance, if the 5-year bond with a face value of Rs. 100 is traded in the market at Rs. 105, the coupon rate would be paid as a percentage of Rs. 100, and not at Rs. 105. The coupon rate is determined when the bonds are issued.
Though it looks similar to interest rates, there is a fine line of difference between the two. A coupon rate can be interpreted as a yield on fixed-income security like bonds. If the investor purchases the bond from the market, at a value higher or lower than the face value, the yield would differ. For instance, if an investor purchased a bond at Rs. 1100, the face value of which is Rs. 1000, with an interest rate of 5%, they will get the interest of Rs. 50. Here, the yield of the investor would be nearly 4.55%, as the bond is bought at a premium.
Coupon rates are determined based on the prevailing market rate, and the creditworthiness of the issuer. Investors would be ready to invest in the bond only if it pays a higher return as compared to prevailing rates. If the creditworthiness of the issuer is lower, the bondholders are compensated by higher coupon payments for the high amount of risk. However, if the ratings of the bond are higher, the coupon payment offered is relatively lower.
- Fixed Coupon Rate: If the bondholders get a fixed rate of coupon during the entire tenure, it is a fixed coupon rate. In this type of coupon rate, the investors already know the interest income they will receive. Usually, municipal bonds have a fixed coupon rate.
- Variable Coupon Rate: If the bondholders get fluctuating returns during the tenure, the bond will have a variable coupon rate.
What are zero-coupon bonds?
One of the types of bonds available for investors is Zero-coupon bonds. As the name implies, these bonds do not pay coupons during their tenure. Rather, such bonds are issued at a huge discount and repaid at par value. The difference becomes the return for bondholders. Usually, zero-coupon bonds are issued for a longer tenure.
For example, an investor purchases a zero-coupon bond, with a face value of Rs. 1000, at Rs. 350 which will mature after 20 years. No coupon payments are being made. At the end of 20 years, the investor will be repaid with Rs. 1000.
The price of a zero-coupon bond is calculated using the following formula.
For annual zero-coupon bond,
Price = Face value / (1 + r)n
For semi-annual zero-coupon bonds,
Price = Face value / ( 1 + r/2)n*2
Here, face value = value of bond repayable at the maturity
r = Required rate of return / interest rate
n = Number of years till maturity
The earlier the investor purchase this bond, the longer the maturity and the lesser the investor need to pay for it, and vice versa.
How are coupon rates determined?
The coupon rate of the bond is determined through a step-by-step process:
The first step is to arrive at the value of bond issuance, which is known as the face value or par value.
The next step is to determine the number of times coupon payments to be made during a year. The issuer may pay the interest quarterly, semi-annually, or yearly. When all the coupon payments are summed up, the resultant number is the annual coupon payment of the bond.
The final step is to calculate the coupon rate, by dividing the annual coupon payment by the face value of the bond.
For example, ABC company decides to issue a bond with a face value of Rs. 1000. The company decided to pay the interest of Rs. 50 each quarter.
Here, annual coupon payments = Rs. 50*4 = Rs. 200
Coupon rate = annual coupon payment / face value of bond
= 0.2 or 20%
The coupon rate informs the investors at which rate they will be compensated for buying the bond. The coupon rate can be calculated using the total annual payment and the face value of the bond. This rate decides whether the bond will trade at a discount or premium in the secondary market.
Frequently Asked Questions Expand All
The coupon rate bond can be calculated by dividing the annual coupon payment by the face value of the bond. For example, If a bond with a face value of Rs. 1000 pays Rs. 50 interest semi-annually, the annual coupon payment amounts to Rs. 100. Therefore, the coupon rate can be calculated as 100/1000 = 0.1 or 10%.