Coupon Rate

The coupon rate is the annual interest a bond's issuer promises to pay, expressed as a fixed percentage of the bond's face value (also called par value). It is written into the bond at issuance and stays constant for the bond's whole life. The name is literal history: bonds once carried detachable paper coupons that the holder clipped and redeemed for each interest payment. Because the rate is a percentage of face value rather than of the price a buyer pays in the market, the coupon rate describes the bond's contractual payment, not the return an investor earns.

The coupon rate answers one narrow question: how many dollars of interest does this bond pay each year? Multiply the coupon rate by the face value and the answer is fixed for the life of the bond. When people call something "a 5 percent bond," they are naming its coupon. The rate an investor actually earns is a different question, because a bond's price moves after issuance while its coupon does not. Two other measures answer the return question. Current yield divides the annual coupon by the current market price. Yield to maturity goes further and folds in the gain or loss between the purchase price and the face value repaid at maturity. Coupon rate, current yield, and yield to maturity all coincide only in the one case where a bond trades at exactly its face value. Buy the bond below face value and the yield measures rise above the coupon; buy it above face value and they fall below it. A zero-coupon bond takes this to the limit: it has a coupon rate of zero and pays all its return as the difference between a discounted purchase price and the face value at maturity.

The coupon rate is applied to face value to produce the dollar payment, which is then usually split into two semiannual installments.

A hypothetical example. An investor buys a corporate bond with a $1,000 face value and a 6 percent coupon rate.

• Annual interest: 6 percent × $1,000 = $60 a year.
• Paid as two installments: $30 every six months.
• This $60 does not change if the bond's market price later rises to $1,050 or falls to $940; the coupon is always 6 percent of the $1,000 face value.

If that investor had instead paid $940 for the bond, the $60 coupon would represent a current yield of about 6.4 percent ($60 ÷ $940), and the yield to maturity would be higher still because the buyer also collects the $60 gain to face value at maturity. The coupon rate stays 6 percent throughout; only the yield measures move with price.

Pros

• Fixes the dollar income a bondholder receives, which is the predictability that draws many investors to bonds in the first place.
• Simple to compute: coupon rate times face value gives the annual payment.
• Names the bond unambiguously in the market, where bonds are routinely referred to by issuer, maturity, and coupon.

Cons

• Says nothing about the return of buying the bond today, because it ignores the price paid.
• A high coupon rate can look attractive while the bond trades at a premium that erases the advantage by maturity.
• Fixed payments lose purchasing power to inflation, since the coupon never rises even as prices do.