What is a Coupon Rate?
Coupon rate, or interest rate, is the amount of money an investor will receive from a bond or other fixed-income security. The rate is expressed as a percentage of the security’s face value. In other words, it’s the amount of interest the investor will earn from the security annually. This rate can be fixed or variable, depending on the security and market conditions.
Types of Coupon Rates
The types of coupon rates in fixed-income securities vary depending on the security and the issuer. Generally, the coupon rate of a fixed-income security is determined at the time the security is issued. Here are some of the most common types of coupon rates:
Fixed Rate
A fixed rate coupon rate pays a fixed amount of interest on the face value amount of the security. For instance, a bond with a $1,000 face value and a coupon rate of 4% will pay $40 of interest annually per $1,000 of face value of the security. This type of coupon rate is most commonly used by governments, supranational institutions, public and private entities, and municipalities as part of their debt obligation financing.
Floating/Variable Rate
A variable rate coupon rate pays an amount of interest that fluctuates over time and is usually tied to a predetermined benchmark. For example, a variable coupon rate bond may pay an amount of interest equivalent to the three-month LIBOR rate plus 2%. The amount of interest paid under this type of coupon rate may vary depending on the benchmark set forth in the bond’s terms. Variable coupon rate securities are most often utilized by corporations, financial institutions, and government bodies.
Zero-Coupon Rate
As its name implies, a zero-coupon rate bond does not pay any amount of interest, only the face value of the security. The bond is issued at a discount to the face value, which is paid to the investor at maturity. This type of coupon rate is beneficial to investors who wish to receive their returns at a later date and are looking for discounted upfront costs.
Rising Rate
Rising rate securities are a type of coupon rate bond that pays a higher amount of interest as time goes on. This type of security is beneficial for investors who anticipate their returns to increase in the near future. After the initial rate is set, the coupon rate may increase at specific predetermined intervals, such as every three months, six months, or annually.
Inverse Floating Rate
Similar to a rising rate security, an inverse floating rate bond also has an increasing coupon rate over time. However, unlike a rising rate security, the rate increases at a predetermined rate. This type of security is beneficial for investors who are interested in hedging their investments against faster increasing interest rates.
Inflation-Linked Coupon Rate
Inflation-linked coupon rate bonds pay a fixed coupon rate that is tied to an inflation index. The interest payments made on the security are adjusted on a periodic basis in relation to the underlying inflation index. Thus, investors will receive a higher payment if the inflation rate rises and a lower payment if the inflation rate falls. This type of security is beneficial for investors looking for a return tied to the inflation rate.
Whole Coupon Rate
A whole coupon rate is a bond wherein the face value of the security is paid out over the life of the bond through periodic payments. This type of coupon rate is usually paid out at par over the life of the bond, resulting in the total coupon payments being equal to the face value of the security.
Coupon rates in fixed-income securities are determined at the time they are issued. The type of coupon rate is determined by the security, issuer, and investor goals. Some of the most common types of coupon rates are fixed rate, floating/variable rate, zero-coupon rate, rising rate, inverse floating rate, inflation-linked coupon rate, and the whole coupon rate. Investors should have a full understanding of these types of coupon rates and the potential investment opportunities available.
