What Is the Coupon Rate Bond Formula?

Bonds are methods for companies or governmental agencies to raise money. Unlike stock, where you actually buy a small amount of the company, bonds are a loan to the entity. Just like a bank, you receive interest on your money when you loan it to the originator of the bond. The coupon rate is the interest rate of the bond.

History

Originally, bonds had several coupons attached. Each one had a different coupon date on it. When it was time to cash in the bonds, the bearer simply detached the coupon and mailed or presented it to the company for payment. Since registration of bonds in the name of the owner now occurs, the coupon payments go directly to the owner of the bond and you no longer have coupons to detach.

Features

Before you understand the coupon rate bond formula, you need to know some of terms on a bond. The face of the bond shows all the features and important data for the bond. It shows the maturity date expressed as a year. When you buy a bond, if the maturity date is 2020 and the year is 2009, then it has 11 years to maturity. The coupon rate of the bond shows as a percentage, the interest rate they pay every year you hold the bond. There's another feature that shows the frequency of payment. It is usually annual or semi-annual. That means that the issuer pays interest once a year or twice a year. If the bond is convertible, which means you can exchange it for stock, the face shows the conversion rate on the bond. There's also par value, which is the amount the company pays when you redeem the bond. This amount isn't necessarily what you pay for the bond.

Types

There are many different types of bonds. There are asset-backed bonds and those based on the general credit of the issuing entity. The coupon rates are higher for companies that have bad credit or are start-up companies. These are high-yield bonds, sometimes referred to as junk bonds. Some bonds have an estate feature to entice investors. These pay slightly lower coupon rates but if one of the owners die, they pay the face value immediately. Often lending institutions issue these types of bonds to raise money for loans to consumers. Government bonds are either taxable or tax-free. If they are U.S. government bonds, the paying power of the United States government backs them. State and local entities have the opportunity to issue U.S. income tax-free bonds. This allows the bearer to collect their interest tax free, but the coupon rate is often less.

Function

The coupon rate formula is very simple. Change the coupon rate on the bond from a percentage to a decimal. If the rate is 8 percent, the number as a decimal is .08. Multiply that number times the par value of the bond. If the bond is $10,000 then you simply multiply .08 times 10,000 and come up with the number $800, which is the annual payment of interest. If the bond pays semi-annually, divide the number by two for each payment.

Misconceptions

The coupon rate isn't the actual rate you'll receive on the bond. Since the bonds often sell for more or less than par value, the yield of the bond varies according to what you paid for it. If the company or entity is strong and the rate of the bond is higher than the interest rate environment, you might pay a premium for the bond. That means you pay more than the par value. If the company has an economic turn for the worse, the maturity date is a long way out, or the interest rate environment is higher, then you pay a discount. The coupon rate no longer is your actual interest. Instead, you divide the answer from the coupon rate formula by the actual price you paid to get the current yield.