Bond rates are the predetermined interest rates paid by the issuer of a bond, note or any other fixed income security. Also known as coupon rates, bond rates are expressed as a percentage of the face value or principal, on an annualized basis. For example, if a $100 bond pays an annual interest of $7, its bond rate or coupon rate is 7%. The payments can be monthly, quarterly, semi-annually or annually, depending on the terms of the bond.
However, there are certain bonds, like the zero coupon bonds, that do not make interest payments. They are sold at a price lower than their face value and the bondholder earns from capital appreciation alone. Capital appreciation is the difference between the amount an investor pays for purchasing the bond and the actual par value of the bond, which the investor receives at maturity.
How Bond Rates are Determined
The bond rate depends primarily upon four factors:
Type of bonds: Bond rates depend on bond categories, such as zero-coupon, convertible and income bonds.
- Interest rate: The bond rate is highly sensitive to changes in interest rates. Bonds issued by the government offer coupon rates that reflect the interest rate announced by a nation’s central bank. Competition ensures that bonds issued by companies or other organizations offer similar coupon rates.
- Date of maturity: The farther is the date of maturity (redemption date) from the issue date, the higher would be the coupon rate. Thus, a five-year bond would typically offer a lower coupon rate than a ten-year bond.
- Bond ratings: Credit rating agencies, such as Standard & Poor's and Moody's, assess the risk of certain bonds and issue grades that reflect the issuer’s ability to make interest payments and repay the principal at maturity. Bonds with higher ratings offer lower coupon rates, since they represent lower risk than bonds with lower credit ratings.
Beyond Bond Rates
The bond yield, or the total earnings from a bond, is dependent not only on the bond rate, but also on the capital appreciation (price of a bond). The bond price is determined by the market, taking into account:
- The principal or face value of the bond.
- The redemption date.
- The coupon rate.
- Credit rating of the issuer, which reflects the ability of the issuer to meet the promised principal and interest payments..
- The yield offered by other similar bonds in the market.