Bonds are fixed-income debt securities issued by businesses, governments and governmental organizations to fund operations, large-scale projects and for 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.
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 semi-annually. Some bonds are known as zero-coupon, meaning they pay no interest, only the face value at maturity.
In the case of a 10-year, 8-percent bond with a $1,000 face value paying interest semi-annually, investors will receive 19 payments of $40 interest every 6 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 semi-annual interest payment and the $1,000 principal of the bond. After year 10, the bond has been fully repaid and is worthless.
Coupon vs. Market
The stated rate on a bond is the coupon rate. Companies and governments issuing bonds may typically set the coupon rate at any value they wish, although a number of bond issuers will attempt to set the coupon at a value near the market rate. While bond issuers may set the bond's coupon rate, they generally are not in control of the market price of the bond. It is the market price of the bond that controls the bond's market interest rate.
Selling of a Bond Issue
Once a bond issuer has set a coupon rate and a face value, the bond issuer 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 of a Market Price and Yield
The amount paid by investors for a bond, whether purchased through a direct auction, through 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.