Bonds are fixed-income debt securities issued by businesses, governments and governmental organizations to fund operations, large-scale projects and other capital uses. Most bonds pay an amount of interest, known as the coupon, based on the face value of the bond. Because of the manner in which bonds are traded, the coupon rate often differs from the market interest rate.
TL;DR (Too Long; Didn't Read)
A coupon rate is a fixed rate of return attached to the face value of the bond paid to the purchaser from the seller, while the market interest rate can change dramatically throughout the lifespan of the bond.
A bond is an obligation of a debtor, typically a company or government, to repay a predetermined amount of money, also known as the principal or face value, at a given date in the future. Most bonds pay interest – known as the bond's coupon – annually or semiannually. Some bonds are known as zero-coupon, meaning they pay no interest, only the face value at maturity.
Example of How Bonds Work
In the case of a 10-year, 8 percent bond with a $1,000 face value paying interest semiannually, investors will receive 19 payments of $40 interest every six months for nine and one-half years. At the end of 10 years, the investor will receive a payment of $1,040 – both the $40 semiannual interest payment and the $1,000 principal of the bond. After year 10, the bond matures and is fully paid off, meaning all debt obligations represented by the bond have been honored in full.
Coupon Rates Vs. Market Rates
Understanding the distinct difference between coupon rates and market interest rates is an integral step on the path toward developing a comprehensive understanding of bonds and the debt security marketplace. A coupon rate can best be described as the sum, or yield, paid on the face value of the bond annual over its lifetime. So, for example, if you had a 10-year bond with a value of $1,000 and a coupon rate of 10 percent, the purchaser of the bond would receive $100 each year in interest.
This differs from the market interest rate of a bond, which is a fluctuating value that generally reflects market sentiment. Unlike the coupon rate, the market interest rate of a bond can swing drastically during the lifetime of the bond. For example, in a scenario where experts are predicting economic inflation, the market interest rate for the bond may rise due to the fact that investors will expect more cash to offset the decrease in the value of the currency at large. Generally speaking, if a market interest rate exceeds a coupon rate, the value of the bond will likely drop.
Selling a Bond Issue
Once a bond issuer has set a coupon rate and a face value, the bond issuer logically wishes to obtain the highest possible market price for the bond issue. Typically, private companies will hire an investment bank to underwrite the bond issue. The investment bank, or syndicate of multiple investment banks, will purchase the entire bond issue and resell the bonds to large-scale and institutional investors on the open market. Many governmental entities, such as the United States Treasury, will sell bonds directly to large-scale investors through auctions rather than using an underwriter as a middleman.
Setting the Market Price and Yield
The amount paid by investors for a bond, whether purchased through a direct auction, an underwriter or from another investor is the bond's market price. When the market price is less than face value, then the market rate, or yield, of that bond will be greater than the coupon rate. When the market price is greater than face value, then the market yield of that bond will be less than the coupon rate.
For example, a bond with a $1,000 face value that trades at $1,001 features a market yield that is less than the coupon rate. Therefore, the relationship of the coupon rate and the market yield depends upon the market price of the bond.