Introduction
In today’s scenario, raising funds is mainly done via debt. There are different debt instruments to do so, like, debentures, bonds, public deposits, commercial bills, commercial paper etc. Each of these instruments has varied rates of interest/ return payable on them. An investor needs to know the different rates of return available on various debt instruments to make an informed decision on the type of investment that they wish to make. Various debt instruments come with different kinds of coupon rates or interest rate that makes them less risky debt instruments. They generally provide timely payment of the principal and the interest amount that is payable. However, for many financial analysts, coupon and interest rates are used interchangeably, and less difference is understood between them. A coupon rate is a rate which is calculated on the face value of the bond. This implies that it is estimated on the fixed income security that is primarily impacted by interest rates set by the government and that it is usually decided by the issuer of the bonds. Interest rate is defined as the rate which is charged by the lender of the funds that are determined by the lender. However, it is also manipulated by the government depending upon the market conditions. This article attempts to explain the concepts of coupon rate and interest rate and outline the key differences between the two concepts.
Coupon Rate vs Interest Rate
The critical difference between coupon rate and interest rate is that interest rate is a fixed rate throughout the life of the investment, while the coupon rate changes from time to time, depending upon market conditions. The coupon rate is always estimated on the par value/ face value of the investment. In contrast, the interest rate is calculated considering the riskiness of lending the amount to the borrower. Coupon rates are also termed nominal yield and yield rate. Interest rate is also known as the rate of borrowing, interest rate, prime rate, cost of money and bank rate. The coupon rate pertains to high-risk investments, while the interest rate pertains to low-risk investments. While coupon rate is applied on debentures and bonds, interest rates are applied on debt instruments like personal loans, term loans, home loans etc. Types of coupon rates are zero-coupon rates (no changes in coupon rate), step-up rates (increase coupon rate) and floating- coupon rates (fluctuating). Types of interest rates are nominal interest rate, effective rate and real interest rate.
Difference Between Coupon Rate and Interest Rate in Tabular Form
| Parameters of Comparison | Coupon Rate | Interest Rate |
| Definition | A coupon rate is defined as the nominal yield paid by fixed-income security. | Interest rate is defined as the amount a lender charges a borrower and is a percentage of the principal amount. |
| Fixed/flexible | Coupon rates are generally more flexible and change from time to time. | Interest rates are generally fixed and remain constant. |
| Instruments | The coupon rate is applied on debt instruments like debentures and bonds. | Interest rates are applied on debt instruments like term loans, housing loans, car loans etc. |
| Alternative names | Coupon rates are also termed nominal yield and yield rate. | Interest rate is also known as the rate of borrowing, interest rate, prime rate, cost of money and bank rate. |
| Types | Types of coupon rates are zero-coupon rates (no changes in coupon rate), step-up rates (increase coupon rate) and floating- coupon rates (fluctuating). | Types of interest rates are nominal interest rate, effective rate, and real interest rate. |
| Risk | Coupon rates are applied to risky debt instruments. | Interest rates are generally applied to less risky debt instruments. |
| Decided by | The coupon rate is determined by the issuer of the bond. | The interest rate is determined by the lender. |
What is the Coupon Rate?
A coupon rate is known as the rate which is calculated on the face value of the bond. This implies that it is estimated on the fixed income security that is primarily impacted by interest rates set by the government and that it is usually decided by the issuer of the bonds.
Effect of credit rating on coupon rate:
A coupon rate of a bond/investment is affected by the issuer's credit rating as well as the maturity period. Credit rating is defined as an estimation of how likely the issuer will be able to pay the dues associated with a bond. Often, a poor credit rating indicates that a bond issuer has a higher chance of defaulting. Defaulting means being financially incapable of paying the loan back. Issuers of bonds with a poor credit rating should have a higher coupon rate to compensate for the additional risk.
Maturity and coupon rate:
The maturity period is the length of time a bond is issued for. All external factors remain unchanged; a bond with a longer maturity generally has a higher coupon rate than a shorter-term bond.
Instruments on which coupon rate is applied:
- Debenture- Debenture is defined as a written instrument acknowledging a debt under the common seal of a corporation. It is a contract for repayment of the principal amount after a particular period or sometimes at intervals and for payment of interest at a fixed rate payable, usually either half-yearly or yearly on selected dates. Types:
- Specific Coupon Rate Debentures: Such types of debentures are issued with a specified rate of interest payable on them which is called the coupon rate of interest. This specified rate can be floating or fixed, wherein the floating interest rate is usually tagged with the bank rate.
- Zero-Coupon Rate Debentures: These debentures do not carry a specific interest rate. They are issued at a substantial discount. The difference between the nominal value of the debenture and the issue price is considered to be the amount of interest related to the duration of the debentures.
- Treasury bill- A Treasury bill is defined as an instrument of short-term borrowing by the Government of India that matures in less than a year. They are also called zero-coupon bonds issued by the Reserve Bank of India on behalf of the Central Government. They are given to meet their short-term requirement of funds. Treasury bills are provided as promissory notes. Although they are highly liquid, they have assured yield and negligible risk of default. They are issued at an amount that is lower than their face value and repaid at par. The difference between the issue price and their value of redemption is the interest receivable on them and is called a discount. Treasury bills are issued for a minimum amount of `25,000 and in multiples thereof.
What is Interest Rate?
The interest rate is defined as the amount a lender charges a borrower and is a percentage of the principal. This is the amount loaned. The interest rate on loans taken is typically noted annually. It is known as the annual percentage rate (APR). An interest rate can be applied to the amount earned at a bank or credit union from a certificate of deposit or savings account. Annual percentage yield (APY) is defined as the interest earned on these deposit accounts.
The interest rate is applicable to the principal amount for loans ( the amount of the loan). While the interest rate is the cost of debt for the borrower, it is the rate of return for the lender. The money to be repaid is generally more than the borrowed amount. This is because lenders deserve compensation for the loss of usage of the funds during the period for which the loan is granted. The lender would have had the opportunity to invest the funds elsewhere during this period which would have generated income from the asset. The difference between the total amount that is repayable and the original loan amount is the interest charged.
When a particular borrower is considered to be less risky by a lender, the borrower will be charged a low-interest rate. If the borrower is deemed to be high risk, then the interest rate charged will be higher. This results in a higher-cost loan.
Determination of Interest Rates
The interest rate that is imposed and demanded by commercial banks is determined by several factors, that include even state of the economy. The central bank of a country sets the interest rate. When the central bank ( Reserve bank of India) sets interest rates at a high level, an increase in the cost of debt is observed. This high cost of debt discourages people from borrowing and slows consumer demand. Also, interest rates tend to increase with inflation. To combat the rising inflation, commercial banks may set higher reserve requirements. This results in a tight money supply or greater demand for credit. In an economy with high-interest rates, people resort to saving their money since they receive more from the savings rate. The stock market suffers since investors would instead take advantage of the high rate from savings rather than invest the amount in the stock market, which gives lower returns. Firms and production units also have limited access to capital funding via debt. This leads to an economic contraction. Often, economies are stimulated during periods of low-interest rates. This is because borrowers have access to loans at cheaper rates. Since interest rates are low on savings, businesses, as well as individuals, are more likely to spend and purchase riskier investment avenues. This spending fuels the economy and also provides an injection to the capital markets. This further leads to an economic expansion. Though governments prefer lower interest rates, they eventually lead to market disequilibrium where demand exceeds supply causing inflation. Thus, it is concluded that when inflation occurs, interest rates increase.
Main Differences Between Coupon Rate and Interest Rate In Points
- A coupon rate is a rate that is calculated on the face value/original value of the bond/debenture. The interest rate is the rate that is calculated or imposed by the lender of funds. Thus, it is determined only by the lender.
- Coupon rates change from time to time as they are more volatile, while interest rates are usually fixed and remain constant since it is decided by the lender alone.
- The coupon rate is applied on debt instruments like debentures and bonds, while interest rates are used on any types of loans availed from banks, financial institutions, or individuals. Examples of loans for interest rates are term loans, housing loans, car loans etc.
- Coupon rates are also known as yield rates and nominal yields. The alternative names for interest rates are borrowing rate, rate of interest, prime rate, cost of money and bank rate.
- The three types of coupon rates are zero-coupon rates, step-up rates and floating- coupon rates. On the other hand, the three types of interest rates are nominal interest rate, effective rate, and real interest rate.
- Coupon rates are applied on risky debt instruments and are thus influenced by government standards, while interest rates are used on less risky debt instruments and therefore remain fixed.
Conclusion
Different types of debt instruments carry different types of return rates. Two of the most common types of rates of return are coupon rates and interest rates. They are often used interchangeably; however, it is imperative to know the difference between the two to make a well-informed decision on the types of investment to be made since both the rates are applicable to different kinds of debt instruments. A coupon rate is defined as the rate which is calculated on the face value of the bond. This implies that it is estimated on the fixed income security that is primarily impacted by interest rates set by the government and that it is usually decided by the issuer of the bonds. Interest rate is defined as the rate which is charged by the lender of the funds that are determined by the lender. However, it is also manipulated by the government depending upon the market conditions. This article has attempted to explain the critical differences between the concept of coupon rate and interest rate. It has also demonstrated the idea of coupon rate in detail, its relationship with credit rating and maturity period, as well as the instruments on which it is applicable. Further, it has also explained the concept of interest rate and its determination.
References
- www.wallstreetmojo.com
- Class 11 & Class 12 NCERT business studies textbook
- Class 12 NCERT Accountancy textbook volume 2
