In the context of bonds, a coupon refers to the periodic interest payment that a bond issuer has to make to the bondholder.
It is a fixed amount of money paid to the bondholder at regular intervals. It can come in next to whatever cyclical period the issuer, and the investor, agrees to.
However, coupons are typically issued annually or semi-annually, until the bond reaches maturity date.
The coupon represents the interest income earned by the bondholder as compensation for lending money to the issuer.
The coupon rate, on the other hand, is the annual interest rate expressed as a percentage of the bond’s face value (also known as the par value or principal).
It is the rate used to calculate the coupon payment amount. For example, if a bond has a face value of N1,000 and a coupon rate of 5%, the annual coupon payment to be made would be N50 (5% of $1,000).
A semi-annual coupon of 5% would therefore mean that the N50 is divided into two equal halves and paid twice in an official calendar year.
The coupon rate mostly remains fixed throughout the life of the bond, unless it is a variable or floating rate bond, which can adjust periodically based on a reference rate such as NIBOR, Nigerian Inter–Bank Offered Rate, or a benchmark interest rate as sometimes determined by the underwriter, investment bank, and/or the issuer of the bond.
Though rare, Investors have however been known to agree to invest in a program at a benchmark interest rate as determined by them.
The coupon rate in a bond issuance program is therefore determined by several factors, and it is mostly set by the issuer of the bond, but, in some cases, by the intended target or investors of the bond. Some other key considerations are:
- Market Conditions: The prevailing interest rates in the market play a significant role in determining a coupon rate. If interest rates are low, an issuer may offer lower coupon rates. This may not attract quality investors but it at least reduces the risk of the issuer going into default. Conversely, if interest rates are high, issuers may offer higher coupon rates to make the bonds more appealing to investors.
- Creditworthiness of the Issuer: The creditworthiness or credit rating of the issuer also greatly influences a coupon rate. A highly-rated issuer with a lower risk of default may be able to offer bonds with much lower coupon rates since investors perceive their loan requirements as safe investments. Conversely, lowly-rated issuers may need to offer higher coupon rates to compensate investors for the additional risk they may have to bare by investing in their bond which may have a higher threat of default.
- Bond Maturity: The time to maturity of the bond also greatly affects the coupon rate. Longer-term bonds typically have higher coupon rates compared to shorter-term bonds. This is because investors would want to be compensated for the longer period during which they tie up their funds in your bond program.
- Bond Market Demand: Investor demand for bonds can also impact coupon rates. If there is high demand for the bonds, issuers may be able to offer lower coupon rates. On the other hand, if demand is low, issuers may have to increase the coupon rate to attract investors to their offer.
- Competitive Landscape: The coupon rates of similar bonds issued by other entities within the same industry or sector can sometimes, and in more cases than one, influence the rate a coupon can be offered in an issuance program. Issuers may set their coupon rates in line with prevailing rates to comparable bonds, but risk competitiveness. Or, set the rate higher than their peers or prevailing market rates to be able to attract greater funding or more quality investors with larger funds to invest. Issuers are however typically advised to ensure their ability to fulfil obligations to a higher-than-average market rate before offering them, to avoid the risk of default.
- The Investors: As previously stated, and depending on the peculiarities of the bond program, and the issuer’s desire to attract quality investors, an issuer may allow the coupon rate to be determined by the investor through an ‘open bid’, or a book building process. In the open bid process, which usually ties in with the book building, the underwriter, and/or investment bank working as parties to the offer, present all the requisite information, including company history, going financial stance, board composition, etc., about the issuing company to investors, specific or otherwise – but mostly to specific investors.
The underwriter then allows a period where these officially respond with how much they are willing to accept as coupon for their investment in the program, dependent on some, or all of the already stated criteria, from 1 to 4 above.
A lot of the time, differing bids are usually received. The underwriter sits down with the issuer and determines to offer the program at either the lowest band of the received bids, the higher band, or at the median band.
This determinant is taken into serious consideration of what the program stands to lose, or gain, from offering at any of the bands.
And then a decision is taken and typically presented to the most interested, or sort after, investors first.
Ultimately, the coupon rate is a negotiation between the issuer and its potential investors in the bond market, considering various market factors and the issuer’s specific financial needs and/or peculiar circumstances.
It is however always advisable to work with experts in the sector or knowledgeable business advisors to guide you through the best determinable coupon rate before pursuing a bond issuance program in a bid to get the best out of the program while fulfilling your obligations to all parties involved.
Brain Essien is a certified financial analyst and business process consultant, with expertise in business plan formulation and pitch deck design, brand management, digital marketing, crowd/private equity and seed fund brokerage.
mcbrainandcompany@gmail.com. +234703-444-6041
