The coupon rate of a bond refers to the fixed annual interest rate paid by the issuer to the bondholder. It's called a "coupon" because in the past, when bonds were physical certificates, bondholders would tear off physical coupons attached to the certificates and redeem them for interest payments. Today, with electronic trading, the term "coupon" is still used to describe the interest rate.
For example, if a bond has a face value of $1,000 and a coupon rate of 5%, it means the issuer will pay $50 in interest per year ($1,000 * 0.05) to the bondholder, typically in semiannual or annual installments.
Difference between Coupon Rate and Yield:
Coupon Rate: The coupon rate is the fixed percentage of the face value of the bond that the issuer agrees to pay to the bondholder as interest. It remains constant throughout the life of the bond, regardless of fluctuations in market interest rates or changes in the bond's price.
Yield: Yield, on the other hand, represents the return an investor can expect to receive from holding the bond. It takes into account not only the coupon payments but also any potential capital gains or losses if the bond is bought or sold at a price different from its face value. Yield is expressed as an annual percentage and can be calculated in different ways, such as current yield, yield to maturity (YTM), or yield to call (YTC).
The key difference between coupon rate and yield is that the coupon rate is fixed, while the yield can vary based on changes in market conditions, such as interest rates and the bond's price. If the bond's price rises above its face value, the yield will be lower than the coupon rate, and if the bond's price falls below its face value, the yield will be higher than the coupon rate. Investors use yield as a measure of the bond's overall attractiveness and its potential to provide returns compared to other investment opportunities.
