A bond'scoupon rate (sometimes abbreviated simply to "coupon") isn't affected by its price. However, the coupon rate influences the bond's price, by influencing the bond's competitiveness and value in the open market.
Key Takeaways
- The coupon rate on a bond vis-a-vis prevailing market interest rates has a large impact on how bonds are priced.
- If a coupon is higher than the prevailing interest rate, the bond's price rises; if the coupon is lower, the bond's price falls.
- The majority of bonds boast fixed coupon rates that remain stable, regardless of the national interest rate or changes in the economic climate.
- A bond's current yield, however, is different: a percentage based on the coupon payment divided by the bond's price, it represents the bond's effective return.
How Does A Bond’s Coupon Interest Rate Affect Its Price?
How Bond Coupon Rates Work
A bond's coupon rate denotes the amount of annual interest paid by the bond's issuer to the bondholder. Set when a bond is issued, coupon interest rates are determined as a percentage of the bond's par value, also known as the "face value." A $1,000 bond has a face value of $1,000. If its coupon rate is 1%, that means it pays $10 (1% of $1,000) a year.
Coupon rates are largely influenced by prevailing national government-controlled interest rates, as reflected in government-issued bonds (like the United States' U.S. Treasury bonds). This means that if the minimum interest rate is set at 5%, no new Treasuries may be issued with coupon rates below this level. However, preexisting bonds with coupon rates higher or lower than 5% may still be bought and sold on the secondary market.
When new bonds are issued with higher interest rates, they are automatically more valuable to investors, because they pay more interest per year, compared to pre-existing bonds. Given the choice between two $1,000 bonds selling at the same price, where one pays 5% and the other pays 4%, the former is clearly the wiser option.
Coupon Interest Rate vs. Yield
Most bonds have fixed coupon rates, meaning that no matter what the national interest rate may be—and regardless of market fluctuation—the annual coupon payments remain static. For instance, a bond with a $1,000 face value and a 5% coupon rate is going to pay $50 in interest, even if the bond price climbs to $2,000, or conversely drops to $500.
But if a bond's coupon rates are fixed, its yields are not. There are several types of bond yields, but one of the most relevant is the effective or current yield. Current yield is derived by dividing a bond's annual coupon payments—that is, the interest the bond is paying—by its current price. This calculation results in the actual return an investor realizes on that bond—its effective interest rate, in effect.
Say that a $1,000 face value bond has a coupon interest rate of 5%. No matter what happens to the bond's price, the bondholder receives $50 that year from the issuer. However, if the bond price climbs from $1,000 to $1,500, the effective yield on that bond changes from 5% to 3.33%.
Conversely, if the bond price falls to $750, the effective yield is 6.67%.
Cardinal rule of bonds No.1: The higher the bond price, the lower the yield.
General interest rates substantially impact stock investments. But this is no less true with bonds. When the prevailing market rate of interest is higher than the coupon rate—say there's a 7% interest rate and a bond coupon rate of just 5%—the price of the bond tends to drop on the open market because investors don't want to purchase a bond at face value and receive a 5% yield, when they could source other investments that yield 7%.
This drop in demand depresses the bond price towards an equilibrium 7% yield, which is roughly $715, in the case of a $1,000 face value bond. At $715, the bond's yield is competitive.
Conversely, a bond with a coupon rate that's higher than the market rate of interest tends to rise in price. If the general interest rate is 3% but the coupon is 5%, investors rush to purchase the bond, in order to snag a higher investment return. This increased demand causes bond prices to rise until the $1,000 face value bond sells for $1,666.
Cardinal rule of bonds No. 2: As interest rates rise, bond prices fall.
Other Impacts on Bond Prices
In reality, bondholders are as concerned with a bond's yield to maturity, especially on non-callable bonds such as U.S. Treasuries, as they are withcurrent yield because bonds with shorter maturities tend to have smaller discounts or premiums.
The credit rating given to bonds also largely influences the price. It's possible that the bond's price does not accurately reflect the relationship between the coupon rate and other interest rates.
Because each bond returns its full par value to the bondholder upon maturity, investors can increase bonds' total yield by purchasing them at a below-par price, known as a discount. A $1,000 bond purchased for $800 generates coupon payments each year, but also yields a $200 profit upon maturity, unlike a bond purchased at par.
How Are Coupon Rates Affected by Market Interest Rates?
Coupon rates are based on prevalent market interest rates. The latter can change and move lower or higher than a bond's coupon rate, which is fixed until the bond's maturity. This fluctuation makes the value of the bond increase or decrease. Thus, bonds with higher coupon rates than the prevailing market interest rate provide a margin of safety.
What's the Difference Between Coupon Rate and Yield to Maturity?
Yield to Maturity (YTM) refers to the percentage rate of return for a bond assuming that the investor holds it until maturity. At the time it is purchased, a bond's yield to maturity and its coupon rate are the same. However, while the coupon rate is fixed, the YTM will vary depending on the market value and how many payments remain to be made.
What Is a Bond Credit Rating?
The credit rating is a grade given to bonds to evaluate their credit quality. Rating services such as Standard & Poor's and Moody's issue these ratings to provide some insights into the financial strength of a bond issuer, or its ability to pay a bond's principal and interest in a timely fashion. Bond ratings use letters and range from “AAA” (the highest grade) to “D” (the lowest).
The Bottom Line
The prevailing market interest rates affect the coupon rate of a bond, and this, ultimately, affects the price of the bond. As a rule of thumb, if a coupon rate is higher than the prevailing market interest rate, the bond's price rises; if the coupon is lower, the bond's price falls. Besides the prevailing interest rates, other factors that affect a bond's price are yield and the bond's rating.
