Your Money: Know how bonds get their coupon rates

The bids will be ranked in ascending order.

By Sunil K. Parameswaran

Bonds are typically issued as par, and hence the coupon rate should be set so that it reflects prevailing market conditions. This is because, for a bond to trade at par, the coupon must be equal to its yield to maturity. The coupon of a corporate bond will be higher than that on a comparable government bond, because of the default risk that is inherent in the former. The investment bank that is handling the issue will advise the company on the coupon to be set.

Market clearing yield
For government securities, the coupon is determined by the market. Potential buyers will indicate the quantities sought by them and the minimum yield they are prepared to accept. The bids will be ranked in ascending order. The quantity at which supply equals demand is called the market clearing yield, the stop yield or the high yield. In the US the market clearing yield will be rounded down to the nearest integer multiple of 0.125 and this will be set as the coupon.

If the market clearing yield itself were to be an integer multiple of 0.125, then the coupon will be equal to the yield and the bonds will be issued at par. Else the bonds will be issued at a discount. In India, the coupon is set equal to the market clearing yield, and the bonds are issued at par.

Amortising bond
If a bond is insured, it will carry a lower coupon. If it is an amortising bond, or has a sinking fund provision, the coupon will be lower. In the case of the former, the principal is received in instalments. Consequently, the default risk is less than that of a plain vanilla bond, where the entire principal is paid as a lump sum amount at the end, along with the last coupon. In the case of a sinking fund provision, there are two possibilities.

The issuer may periodically buy back a percentage of outstanding bonds from the market. Else it may periodically deposit money into an account administered by a trustee, so as to ensure that adequate funds are available to pay off the face value of the issue at maturity.

Bonds with embedded options have coupons that are different from those of plain vanilla bonds. In the case of puttable bonds, the option is held by the investor and the coupon will be lower. This is also true for convertible bonds. In the case of callable bonds however, the option is with the issuer and will consequently manifest itself as a higher coupon.

Call & put option
A bond may have both a built in call as well as a put option. The coupons of such bonds may be comparable to that of similar plain vanilla bonds. Convertible bonds may include a call provision. By invoking the call option, the issuer can force conversion. In this case, too, there are two offsetting options, one with the issuer and the other with the investor, and there will be implications for the coupon.

The better the credit rating for a bond, the lower will be the coupon. Thus, investment grade bonds will carry lower coupons than junk bonds. Within the junk bonds category, fallen angels will carry lower coupons than original issue junk bonds.

The writer is CEO, Tarheel Consultancy Services