Bond
What is coupon rate?
TL;DR - The coupon rate in a bond is the fixed annual interest rate that the bond issuer agrees to pay to bondholders.
The coupon rate in a bond refers to the fixed annual interest rate that the issuer of the bond agrees to pay to bondholders. It is expressed as a percentage of the bond's face value (also known as par value or principal) and is used to calculate the periodic interest payments the bondholder will receive.
When a company, government, or other entity issues a bond, they promise to make regular interest payments to the bondholders, typically on a semi-annual basis. The coupon rate is the rate at which these interest payments are made, and it remains constant throughout the life of the bond.
For example, if a bond has a face value of 1,000, which is 50 each year until the bond matures.
It's important to note that the coupon rate is used to calculate the fixed interest payments, but the actual yield or return an investor earns from holding the bond may be different. If the bond is bought at a discount (below its face value) or a premium (above its face value) in the secondary market, the effective yield will differ from the coupon rate. This is because the yield takes into account the bond's purchase price and the total interest income received over the bond's life.
Why does a bond's market price and yield move inversely?
The inverse relationship between the market price of a bond and its yield is a fundamental concept in fixed-income investing known as bond price-yield relationship. This relationship can be explained as follows:
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Bond Yield: The yield of a bond represents the effective interest rate earned by an investor on the bond. It is the annualized return an investor can expect to receive from holding the bond. Bond yields are typically expressed as a percentage.
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Market Price of Bond: The market price of a bond refers to the current price at which the bond is trading in the market. It is the price at which investors are willing to buy or sell the bond.
The reason for the inverse relationship between the market price of a bond and its yield is related to the concept of opportunity cost. When bond yields rise, meaning the interest rates in the market increase, newly issued bonds offer higher yields than existing bonds. Investors demand a higher return for their investment to compensate for the higher interest rate environment.
As a result:
- If the yield of a bond increases, it becomes more attractive to investors compared to other bonds available in the market. Investors seeking higher returns will be willing to pay less for existing bonds, leading to a decrease in the market price of the bond.
- Conversely, if the yield of a bond decreases, it becomes less appealing in comparison to new bonds with higher yields. Investors may be willing to pay a premium for the existing bond to secure its higher yield, leading to an increase in the market price of the bond.
In summary, the market price of a bond moves in the opposite direction to its yield due to the principle of opportunity cost: as bond yields rise, bond prices fall, and vice versa. This relationship is critical for investors to understand, as changes in interest rates and market conditions can significantly impact the value of their bond investments.
- Further readying: Inverse Relation Between Interest Rates and Bond Prices
- Bond Funds vs. Bond ETFs: What's the Difference?
Coupon rate vs yield
Coupon rate is the interest rate paid by the bond issuer, expressed as a percentage of the bond's face value. Yield, on the other hand, is the return you can get when buying the bond at its current market price. If the market price equals the par value, coupon rate and yield are the same.
The coupon rate remains fixed, but yield changes with the bond's price. When the market price is below par value, yield is higher than the coupon rate, and when it's above par value, yield is lower. Yield to maturity (YTM) is distinct from current yield, but further details on YTM are for another discussion.