How Coupon Rates Affect Bond Price Volatility

The coupon rate, or the annual interest rate a bond pays based on its face value, affects the volatility of bond prices when market interest rates fluctuate. Generally, when interest rates rise, bond prices fall. Therefore, the coupon rate has an inverse relationship with a bond's price volatility.

Bonds with a higher coupon rate tend to have higher yields and less sensitivity to price fluctuations. Bond price volatility and coupon rate are also linked to bond duration and impact how quickly an investor can recover bond investments.

Investors generally choose to invest in a particular bond based on its rate of return.

According to the Corporate Financial Institute, the issuer's creditworthiness, the prevailing interest rate and the market price of a bond will all directly affect the coupon rate of a bond. If the coupon rate of a bond is lower than the market interest rate, the investment may not look as attractive.

Similarly, the type of bond and the financial security of the bond issuer matter in relation to the coupon rate. While government bonds are considered low risk, some corporate bonds may pose a credit risk that investors may back away from without a higher coupon rate to compensate.

Bonds with higher coupon rates pay higher coupon payments, allowing investors to be paid back their initial investment costs sooner in terms of the time value of money, thus subjecting bond prices to interest rate change to a lesser degree.

The coupon rate is linked to bond duration, a concept used to measure bond price volatility directly. Bond duration is not the same as a bond's maturity date. Instead, it is the average time it takes to receive all periodic cash flows as measured in their present value. A higher duration means a longer time an investor waits to receive coupon payments and return of principal invested.

The concept of bond duration illustrates two equivalent scenarios regarding how long a bond investment can be recovered: receiving a number of payments over the maturity term or one payment at the end of the bond duration.

To calculate bond duration, the number of years to receive each cash payment is totaled and weighted by the percentage of each cash payment's present value over the sum of the present values of all cash payments, which is the investment cost.

The higher the coupon rate and cash payments, the faster the bond investment is recovered and, thus, the shorter the bond duration is.

Bond duration makes it possible to compare the price volatility of bonds of different coupon rates and maturity terms on a single basis.

As Nuveen explains, the longer the bond duration, the more volatile the bond price is to changing interest rates. Bond duration is also a direct measure of how much a bond's price will change for an interest rate change of 100 basis points (1 percent). For every 1 percent change in interest rates, a bond with five years in bond duration, for example, will change by 5 percent in price.

As a fixed-income security, a bond typically pays a fixed rate of interest and predictable annual payments. Market conditions and inflation impact a bond's valuation because when interest rates change, that fixed rate will look more or less attractive, affecting the price of the bond and its market value.

Bond investors adjust a bond holding in accordance with changing interest rates to preserve and grow the value of a bond portfolio as measured by the market prices of its various bonds.

When interest rates are likely to rise, the prices of all bonds are expected to fall, notes the Securities and Exchange Commission. Since bonds with lower coupon rates are more likely to have prices fall the most, investors may unload them for bonds with higher coupon rates that hold up better to a rising interest rate environment.

When interest rates decline, the prices of all bonds are expected to rise. In a declining interest rate environment, bond investors typically choose bonds with lower interest rates over bonds with higher interest rates, as bonds with higher interest rates are less volatile and rise less in price.

If two bonds have the same maturity, the one with a lower coupon rate will be more volatile. It will take the investor longer to recoup the investment. Over this extended time period, the bond will be exposed to greater interest rate fluctuations, have a higher interest rate risk and pose greater risk to an investor’s personal finances.

A bond's yield to maturity (YTM) is an estimated annual rate of return based on the idea that an investor buys in at market price and holds the bond until the security has reached its full value or maturity. It is related to a bond's coupon rate or the annual coupon because these two rates of return are equal when the bond's purchase price is its par value.

YTM and coupon rates diverge when an investor pays less than the face value of the bond or as the value of the bond changes in the secondary market due to market interest rates. Coupon rate is a fixed rate over the life of the bond, while the YTM fluctuates based on market price changes.