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The government and corporations issue bonds to raise money to meet their expenses. These expenses can be working capital requirements or financing specific projects. When a firm or the government issues a bond, it announces the coupon rate. The coupon rate is the interest the bond issuer pays to the bondholder on an annual basis. In other words, it is the return an investor can expect from their bond investment. This article explains the coupon rate for bonds, its calculation, importance and difference between coupon rate and yield to maturity in detail.
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What is Coupon Rate in Bonds?
The coupon rate for bonds is the interest bond issuer pays on the face value of the bond. In other words, it is the periodic interest that the issuer of the bond pays the bond buyer. The couponrate of a bond is computed on the face value of the bond. And not on the market price or the issue price.
The government and businesses issue bonds to raise funds for their operations. The bond issuer will pay you interest at the couponrate when you purchase a bond. The bond certificate will have the couponrate. The coupon payments are made on a regular basis – annually or semi-annually. The bond issuer pays interest regularly until the bond matures. Upon maturity, the bond issuer gives the principal amount as well.
It is important to note that the coupon and interest rates aren’t the same. Let’s understand the difference between the two with an example. Suppose you purchase a bond at INR 5,000, and the couponrate is 10%. You will now get INR 500 as interest every year. As a result, the effective interest rate for you is 10%.
However, let’s say you purchase the same bond at a higher value than its face value. Say, INR 6,000. Since the couponrate is calculated on the face value of the bond, you will receive INR 100. However, the effective interest rate now will be 8.33%.
Similarly, let’s assume you purchase the bond for a value lower than its face value, i.e., INR 4,000. The coupon payment you will receive will still remain the same at INR 100. But the effective interest rate will be 12.5%.
Therefore, the coupon rate and interest rate for a bond are different.
How to Calculate Coupon Rate of a Bond?
The bond’s coupon rate refers to the amount of annual interest the bondholder receives from the bond’s issuer. Coupon rates are a percentage of the bond’s face value (par value) and are set while issuing the bond. Moreover, the coupon payments are fixed for a bond throughout its tenure.
Coupon Rate = (Total Annual Interest Payments / Face Value of the Bond) * 100
Let’s understand couponrate calculation with the help of an example. Suppose Company A issues a bond at face value INR 500. The coupon payments are semi-annual, and the semi-annual payments are INR 50 each. To calculate the couponrate for Company A’s bond, we need to know the total annual interest payments.
Total Annual Interest Payments = 50 + 50 = 100
Coupon Rate = 100 / 500 * 100 = 20%
Therefore, the coupon rate for the Company A bond is 20%.
Importance of Coupon Rate in Bonds
Bonds pay interest to their holders. The coupon rate is the amount of interest the bondholder receives. For most investments, returns vary; however, for bonds, the coupon payments remain the same for the entire tenure of the bond. The coupon payments depend on the face value of the bond and not the market price. Therefore, the current prevailing price of the bond has no impact on the coupon payments.
Furthermore, couponrates have an impact on bond prices. When the interest rates in the market are higher than the bond’s couponrate, the bond prices fall. In other words, since interest rates are higher than the couponrate, other products become attractive, and the demand for bonds falls. As a result, the bond prices fall.
On the contrary, the bond prices increase when the interest rates are lower than the bond’s couponrate. Since the coupon rate is higher, bonds become an attractive investment option. It increases the demand, and as a result, the bond prices rise.
What is Yield to Maturity?
Yield to Maturity (YTM) is the rate of return a bondholder enjoys by holding the bond until maturity. Once the bonds are issued, they are publicly traded in the market like equity shares. Therefore, the YTM value becomes more relevant when the investor purchases the bond in the secondary market.
YTM is the internal rate of return (IRR) of a bond investment. However, the assumption is that the investor holds the bond to maturity, and all the coupon payments are reinvested at the same rate.
Yield to Maturity (YTM) = {(C) + [(FV – PV) ÷ t]} ÷ [(FV + PV) ÷ 2]
Where,
C – Coupon Payment
FV – Face value of the bond
PV – Current price of the bond
t – no. of years to maturity
YTM aims to calculate a bond’s yield based on its current market price. The YTM calculation determines the effective yield an asset should have after it reaches maturity, based on compounding.
Know the Difference’s between Coupon Rate & YTM
The main distinction between the coupon rate and YTM is the return estimation. The coupon rate payments are the same for the bond tenure. While the yield on maturity varies depending on various factors such as the number of years till maturity and the current trading price of the bond.
Let’s assume the couponrate for a bond is 15%. Following is the relationship between the bond prices with the couponrate and YTM.
| Purchase Price of a Bond | Coupon Rate | Yield to Maturity (YTM) |
| Face Value | 15% | 15% |
| Higher than the face value (at a premium) | 15% | Lower than the coupon rate |
| Lower than the face value (at a discount) | 15% | Higher than the coupon rate |
YTM vs Coupon Rate
| Basis of Difference | Yield to Maturity (YTM) | Coupon Rate |
| Meaning | YTM is the rate of return a bondholder enjoys by holding the bond until maturity. | Coupon rate refers to the amount of annual interest the bondholder receives from the bond’s issuer. |
| Payments | YTM is the rate of return a bond generates annually. | Coupon payments are made at regular intervals. |
| Rate | YTM depends on the current market prices and the number of years to bond maturity. | The coupon rate remains the same for the entire duration of the bond. |
| Formula | Yield to Maturity (YTM) = {(C) + [(FV – PV) ÷ t]} ÷ [(FV + PV) ÷ 2] | Coupon Rate = (Total Annual Interest Payments / Face Value of the Bond) * 100 |
| Bond Price | Bond prices and YTM are inversely proportional. | Irrespective of the bond price, the coupon rate for a bond remains the same. |
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