How to Calculate Coupon Rates

How to Calculate Coupon Rates
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Coupon is bond lingo for an interest payment. When you buy a bond, you begin receiving periodic coupon payments for the interest you earned since the last coupon payment. Most bonds pay the same coupon on a set schedule until the bond matures, which is when the issuer pays back the bond's face value and any remaining interest. You calculate a coupon rate by dividing the annual coupon payments by the bond's face value.

Understanding Bond Terms

Corporations and government entities issue bonds when they want to borrow money. Each bond carries a face value, such as $100 or $1,000, that represents the principle portion of the loan. The issuer promises to repay the face value to the bond's owner on the maturity date, which can range from a day to 30 years or more. The term "bond" is usually reserved for debt issued with a maturity period greater than 10 years.

To attract lenders, the issuer forks over interest on a set schedule, usually quarterly, semi-annually or annually. This interest payment is called a coupon, dating back to the days when bondholders would clip coupons attached to bond certificates and mail them to the issuer in order to receive the interest payment when it came due.

The last coupon payment almost always occurs on the maturity date. If you buy a bond on a date other than the coupon date, you also pay the interest that has accrued since the last coupon date. This entitles you to receive the full coupon amount on the next coupon date.

Figuring the Coupon Rate

It's easy to calculate the coupon rate on a plain-vanilla bond – one that pays a fixed coupon at equal intervals. For example, you might buy directly from the U.S. Treasury a 30-year bond with a face value of $1,000 and a semiannual coupon of $20. You'll collect $20 of interest twice a year, or $40 annually. Dividing the $40 annual interest by the $1,000 face value gives a coupon rate of 4 percent.

Some bond types, called floaters, have variable coupon payments that adjust to current prevailing interest rates and therefore do not have a defined coupon rate.

Figuring the Current Yield

Do not confuse the coupon rate with the current yield. The coupon rate is always based on the bond's face value, but you use the purchase price of the bond to figure the current yield. The formula for the current yield is the annual coupon payment divided by the purchase price.

For example, suppose you purchased from a bond broker a $1,000 face-value bond with a $40 annual coupon or $970. Bonds often sell for a price that differs from their face value, also know as par. In this case, the current yield is $40 divided by $970, or 4.124 percent.

Discount and Premium

The current yield will equal the coupon rate only when the bond sells for par value. A discount bond sells for less than par, delivering a current yield higher than the coupon rate. Normally, bonds sell at a discount when the prevailing interest rates are higher than the bond's coupon rate, because buyers are less willing to buy a bond with a relatively puny interest rate and demand a lower purchase price. The reverse situation holds for a premium bond, which sells above par and has a current yield below the coupon rate.