Coupon Rate

The coupon rate fixes the size of each interest payment. Multiply it by the par value to get the annual coupon, then divide by the number of payments per year. A 5% coupon on a 1,000 par bond that pays semiannually produces two payments of 25 a year. Those amounts are set in the bond indenture at issuance and do not depend on what the bond later trades for.

Because the coupon is tied to par, not to price, two investors who buy the same bond at different prices receive exactly the same coupon payments but earn different yields. The coupon rate describes the bond; the yield describes the deal a particular buyer gets at a particular price.

Comparing the coupon rate with the yield the market requires shows where a bond trades. If the coupon rate is above the yield investors require for that risk and maturity, buyers pay more than par: the bond trades at a premium, and the excess is gradually given back as the bond approaches maturity. If the coupon rate is below the required yield, the bond trades at a discount and rises toward par over time. When the two are equal, the bond prices at par.

The same logic orders the yield measures. For a premium bond, the coupon rate is greater than the current yield, which is greater than the yield to maturity; for a discount bond the order reverses. The ordering holds exactly on coupon dates.

Most bonds carry a fixed coupon rate, but structures vary. A floating-rate note pays a coupon that resets each period to a market reference rate plus a quoted margin fixed at issuance, so the coupon rate changes while the margin does not. A step-up bond has a coupon rate that rises on a predetermined schedule. A zero-coupon bond pays no periodic interest; the investor's entire return comes from buying below par and receiving par at maturity.

Some bonds link payments to an index. Inflation-linked government bonds adjust their principal for inflation, so a fixed coupon rate applied to a rising principal produces rising coupon payments.

Candidates should compute coupon payments from the coupon rate, par value and payment frequency; price a bond by discounting those payments at the market discount rate; and explain why the price sits above, below or at par. Questions often test whether three measures can be kept apart: the coupon rate, current yield and yield to maturity, which differ in their denominators and in the cash flows they include.

A common slip is to discount a bond's cash flows at its coupon rate. The coupon rate determines the cash flows; the market discount rate, not the coupon rate, determines their present value. Only when the two coincide does the bond price at par.