How does a bond's coupon interest rate affect its price?

All bonds have a coupon interest rate, sometimes referred to as a coupon rate (or simply a coupon), that denotes the fixed annual interest paid by the issuer to the bondholder. Coupon interest rates are determined as a percentage of the bond's par value, also known as face value, but differ from interest rates on other financial products because it is the dollar amount, not the percentage, that is fixed over time.

Coupon rates are largely influenced by the national interest rates controlled by the government. This means that if the minimum interest rate is set at 5%, no new bonds may be issued with coupon rates below this level. However, pre-existing bonds with coupon rates higher or lower than 5% can still be bought and sold on the secondary market.

Most bonds have fixed coupon rates, meaning that no matter what the national interest rate may be or how much the bond's market price fluctuates, the annual coupon payments remain stable. When new bonds are issued with higher interest rates, they are automatically more valuable to investors because they pay more interest per year compared to pre-existing bonds. Given the choice between two $1,000 bonds selling at the same price, one that pays 5% and one that pays 4%, the former is clearly the wiser option.

For instance, a bond with a $1,000 face value and a 5% coupon rate is going to pay $50 in interest even if the bond price climbs to $2,000 or drops to $500. It is crucial to understand the difference between a bond's coupon interest rate and its yield. The yield represents the effective interest rate on the bond, determined by the relationship between the coupon rate and the current price. Coupon rates are fixed, but yields are not.

Another example would be that a $1,000 face value bond has a coupon interest rate of 5%. No matter what happens to the bond's price, the bondholder receives $50 that year from the issuer. However, if the bond price climbs from $1,000 to $1,500, the effective yield on that bond changes from 5% to 3.33%. If the bond price falls to $750, the effective yield is 6.67%.

General interest rates have a huge impact on investing, and this is also true with bonds. When the prevailing market rate of interest is higher than the coupon rate, such as interest rates may be at 7% but a bond's coupon is only 5% of face value, the tendency is for the price of the bond to drop on the open market. This is because investors do not want to purchase a bond at face value and receive a 5% yield when they could find 7% elsewhere.

This drop in demand pushes down the price of the bond towards an equilibrium 7% yield, which is roughly $715 in the case of a $1,000 face value bond. At $715, the bond's yield is competitive.

Conversely, a bond with a higher coupon rate than the market rate of interest tends to raise in price. If the general interest rate is 3% but the coupon is 5%, investors rush to purchase the bond to achieve a higher return on their investment. This increased demand causes bond prices to rise until, other things being equal, the $1,000 face value bond sells for $1,666.

In reality, bondholders are just as concerned, if not more so, with the bond yield to maturity than with current yield, as bonds with a shorter maturity tend to have smaller discounts or premiums.

The credit rating given to bonds also has a large influence on price. It could be very possible that the bond's price does not accurately reflect the relationship between the coupon rate and other interest rates.

Things get even more complicated when you start adding in call options. All things being equal, however, the coupon rate affects the price of bonds until the current yield equals prevailing interest rates.

Because each bond returns its full par value to the bondholder upon maturity, investors can increase bonds' total yield by purchasing them at below-par prices, referred to as a discount. A $1,000 bond purchased for $800 generates coupon payments each year but also yields a $200 profit upon maturity, unlike a bond purchased at par.