Coupons can save you money on double stuffed Oreo cookies. They can make skee-ball seem like a good use of time. And they can help you save for retirement or college tuition. A bond with semi-annual to annual coupon payments can provide a steady stream of income with the right coupon rate. Though the coupon rate on bonds and other securities can pay off for investors, you have to know how to calculate it first.
What Is Bond Coupon Rate?
Coupon rate measures repayment made by a guaranteed-income security. The term technically applies to any financial product as long as it makes regular, fixed payments against a face value. However, since bonds are the most common guaranteed-income securities, coupon rate most often applies to bonds.
The coupon rate is the annual rate at which the bond repays its holder. It is based on the face value of the bond at issue, otherwise known as the bond’s “par value” or principal. It is not based on subsequent trading. A bond coupon rate is a fixed payment, meaning that it will remain the same for the lifetime of the bond.
For example, you can purchase a 10-year bond with a face value of $100 and a bond coupon rate of 5%. Every year, the bond will pay you 5% of its value, or $5, until it expires in a decade. That active payment occurs on a fixed basis, usually twice a year.
Historically, when investors purchased a bond they would receive a sheet of paper coupons. The investor would return these coupons on a regular basis and receive their payment in exchange. Today most issuers make payments electronically.
How Bond Coupon Rate Is Calculated
Coupon rate is calculated by adding up the total amount of annual payments made by a bond, then dividing that by the face value (or “par value”) of the bond.
For example: ABC Corporation releases a bond worth $1,000 at issue. Every six months it pays the holder $50. To calculate the bond coupon rate we add the total annual payments then divide that by the bond’s par value:
- ($50 + $50) = $100
- $100 / $1,000 = 0.10
The bond’s coupon rate is 10 percent. This is the portion of its value that it repays investors every year.
Bond Coupon Rate vs. Interest
Coupon rate could also be considered a bond’s interest rate. In our example above, the $1,000 pays a 10% interest rate on its coupon.
Investors use the phrase coupon rate for two reasons.
First, a bond’s interest rate can often be confused for its yield rate, which we’ll get to in a moment. The term “coupon rate” specifies the rate of payment relative to a bond’s par value.
Secondly, a bond coupon is often expressed in a dollar amount. For example, a bank might advertise its $1,000 bond with a $50 biannual coupon. This is another way of saying that it pays a 10% return.
Coupon Rate vs. Yield
While coupon rate is the percentage that a bond returns based on its initial face value, yield refers to a bond’s return based on its secondary market sale price. It is what the bond is worth to its current holder.
When the current holder is the initial purchaser of the bond, coupon rate and yield rate are the same.
Once a bond is issued, investors may trade it over the course of its lifetime. Market conditions, coupon rate, and the issuing institution can all influence the aftermarket sale price of bonds. For example, people may look for a safe investment in which to put their money during a highly volatile market. In that environment bond prices rise as investors prioritize moderate risk.
By contrast, during a high-performing market investors may be eager to get their money out of low-yield bonds and into more lucrative investments. In this environment bond prices may fall.
Yield rate is a bond’s rate of return relative to what an investor actually paid for the asset, not relative to its initial face value.
For example, consider again our ABC Corporation bond. It has a par value of $1,000 and twice every year issues a payment of $50 to the note holder. Investor A buys the bond for $1,100 in order to put his money somewhere safe during a market downturn. Later, Investor B buys the bond for $900 as the market has heated up and a safe instrument has lost value. Coupon and yield rates are:
- Coupon Rate: 10%. This does not change.
- Investor A Yield Rate: 9%. The investor paid $1,100 for a bond that returns only $100 per year, making their yield on the bond lower than its coupon rate.
- Investor B Yield Rate: 11%. The investor got a good deal on this bond, collecting $100 per year in exchange for a $900 purchase.
Alternative To Coupon Rate
The major alternative to coupon rate is what is known as a “zero-coupon bond.” In this case, the issuer does not make annual payments. Instead, they sell the bond below par value. At maturity, the bond holder redeems the bond for its entire par value. The note’s rate of return is the difference between its sale price and its price at maturity.
For example, ABC Corporation could issue a 10-year, zero-coupon bond with a par value of $1,000. They might then sell it for $900. The purchaser would hold the note for 10 years and at the date of maturity would redeem it for $1,000, making $100 in profit.
A bond coupon rate can be a nice annual payout for a bond holder. However, it isn’t always as lucrative if you’ve purchased the bond secondhand. If you prize a payout above all else, you may want to consider buying a bond firsthand. If you want to take advantage of market conditions and increase your return, you may want to speak to a financial advisor to make sure you’re getting the best coupon rate possible.
- If you don’t have bonds in your portfolio and aren’t sure if they’re right for you, it may be time to consult a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- You might want to take some time to familiarize yourself with bonds before adding them to your portfolio. If you’re unsure how bonds stack up to certificates of deposit (CDs) or how they fare vs. more volatile stocks, it’s a good idea to get some information before making the choice.
Photo credit: ©iStock.com/amnoonmai, ©iStock.com/BartekSzewczyk, ©iStock.com/malerapaso