What is a Coupon Rate?
Coupon Rate Definition
When bonds are bought by investors, bond issuers are contractually obligated to make periodic interest payments to their bondholders.
Interest payments represent the profit made by a bondholder for loaning money to the bond issuer.
The interest payment is equivalent to the bond’s coupon rate, which is a percentage of the bond’s “principal,”also known as its “face value”or “par value.”
Interest payments continue to be paid to the bondholder until the bond matures, and the face value of the bond is returned to the bondholder.
Coupon Rate Example
For example, an investor purchases a $10,000 bond with a coupon rate of 4%.
The bondholder will therefore earn interest payments of $400 annually, or 4% of $10,000, until the bond matures.
On its maturity date, the bondholder will receive the $10,000 principal back.
It’s important to note that bonds may trade at a premium or discount on the open markets.
However, the coupon rate is a percentage of the bond’s face value, not the amount the bond was purchased for.
How Credit Rating Affects Coupon Rate
A bond’s coupon rate is affected by the issuer’s credit rating and the time to maturity.
Credit rating refers to an estimation of how likely the issuer is to be able to pay the dues of a bond.
Poor credit rating is an indicator that a bond issuer has a higher chance of “defaulting,”or being financially unable to pay back the loan.
Bond issuers with a poor credit rating should have a higher coupon rate to compensate for the additional risk.
Time to maturity is the length of time a bond is issued for.
All else being equal, a bond with a longer maturity will usually have a higher coupon rate than a shorter-term bond.
Coupon Rate Fun Fact
The term “coupon rate”comes from a physical coupon on bond certificates which was clipped and presented for payment on the day the interest payments were due.