SERIES 7 PREP | FINANCIAL REGULATION COURSES
The coupon rate is the fixed annual interest rate stated in a bond's indenture at the time of issuance, expressed as a percentage of the bond's par value, that determines the dollar amount of interest the issuer pays to bondholders on a regular schedule throughout the life of the instrument. It is also called the nominal rate, the stated rate, or the contract rate. The coupon rate and its relationship to the bond's current yield and yield to maturity form one of the most heavily tested areas of the Series 7 and Series 65 examinations.
The Dollar Coupon Payment
The annual dollar coupon payment is calculated by multiplying the coupon rate by the bond's par value. A four percent coupon rate on a one-thousand-dollar par bond produces forty dollars per year in interest. Most corporate and Treasury bonds pay interest semiannually, so that bondholder receives twenty dollars every six months. The total annual payment is always forty dollars regardless of the price at which the bond trades in the secondary market.
This point requires emphasis because it is the source of every yield calculation that follows from the coupon rate. The issuer owes forty dollars per year to the bondholder whether the bond trades at eight hundred dollars, one thousand dollars, or eleven hundred dollars. The dollar coupon is anchored to par value, never to market price. When market interest rates rise and the bond's price falls to eight hundred dollars, the issuer still pays only forty dollars annually. The investor buying that bond at eight hundred dollars receives forty dollars per year on an eight-hundred-dollar investment, producing a current yield above the stated four percent. That relationship between a fixed coupon payment and a changing market price is precisely what drives the yield calculations examined throughout fixed income analysis.
The Coupon Rate as the Nominal Yield
The coupon rate is synonymous with the nominal yield. FINRA's investor education resource on bond yield confirms that coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued that does not change during the lifespan of the bond.
The nominal yield formula is annual coupon payment divided by par value. For a bond paying forty dollars annually on a one-thousand-dollar par value, the nominal yield is four percent. The calculation simply confirms the stated rate and does not require a current market price. This is the defining feature of the nominal yield: it is the only yield measure that remains constant throughout the bond's life, because both the numerator and denominator are fixed contractual amounts.
Every other yield measure — current yield, yield to maturity, yield to call — incorporates the bond's current market price and therefore changes continuously as prices move. The nominal yield does not change even as the bond trades at various prices in the secondary market. A four percent bond is a four percent coupon bond from the day it is issued until the day it matures, regardless of where it trades.
Setting the Coupon Rate at Issuance
When a new bond is brought to market, the underwriting investment bank prices it to sell at or near par. To achieve this, the coupon rate must approximate the yield that investors currently demand for bonds of that credit quality and maturity. If the market yield for comparable ten-year investment grade corporate bonds is five percent on the day of issuance, a new ten-year bond from that issuer will carry a coupon rate close to five percent, allowing it to be issued at approximately par value.
If market conditions change between the time the coupon is set and the time the bonds actually settle, the bonds may price slightly above or below par. A bond issued with a five percent coupon into a market where comparable yields have moved to five and a quarter percent will price at a modest discount to par. A bond issued with a five percent coupon into a market where yields have fallen to four and three quarters percent will price at a modest premium. In each case the coupon rate has already been fixed, and the market price adjusts to make the bond's total return equivalent to prevailing market yields.
The Relationship Between the Coupon Rate and Market Yields
Once a bond is issued and begins trading in the secondary market, the relationship between the coupon rate and prevailing market interest rates continuously determines whether the bond trades at a discount, at par, or at a premium.
When market interest rates rise above the coupon rate, new bonds of comparable quality offer more attractive income than the existing bond. Investors will not pay full par value for a bond paying four percent when new bonds of the same type offer five percent. The price of the existing bond must fall to a level at which the four percent coupon payment, combined with the gain from buying below par and receiving par at maturity, produces a total return equal to the prevailing five percent market yield. The bond trades at a discount.
When market interest rates fall below the coupon rate, the existing bond's fixed payment is more attractive than new bonds coming to market. Investors will pay a premium above par to acquire a bond still paying four percent when new comparable bonds offer only three percent. The bond trades at a premium, and its price rises until the effective total return — accounting for the loss of the premium at maturity — equals the prevailing three percent market yield.
When market interest rates equal the coupon rate, the bond trades at par. The existing bond's fixed payment is precisely competitive with new issues, and no premium or discount adjustment is needed. These three scenarios produce the foundational price-yield relationship that governs all fixed income markets: bond prices and market interest rates move in opposite directions.
The Four Yield Measures and Their Relationship to the Coupon Rate
The coupon rate anchors the four yield measures that every Series 7 and Series 65 candidate must understand and be able to place in the correct order.
The nominal yield, as established, equals the coupon rate and never changes.
The current yield equals the annual coupon payment divided by the bond's current market price. For a bond with a four percent coupon trading at eight hundred dollars, current yield equals forty divided by eight hundred, equalling five percent. For a bond with a four percent coupon trading at eleven hundred dollars, current yield equals forty divided by eleven hundred, equalling three point six four percent. Current yield moves inversely with price because the numerator is fixed while the denominator changes.
The yield to maturity, confirmed by FINRA as the most complete and most important yield measure for bond analysis, is the total annualised return earned by an investor who purchases the bond at its current price and holds it to maturity, assuming all coupon payments are received on schedule. Yield to maturity captures not only the coupon income but also the gain or loss from the difference between the purchase price and the par value received at maturity. For a discount bond, the investor receives the coupon plus a capital gain, so yield to maturity exceeds both current yield and the coupon rate. For a premium bond, the investor receives the coupon but suffers a capital loss at maturity, so yield to maturity is below both current yield and the coupon rate.
The yield to call is calculated like yield to maturity but assumes the bond is redeemed at its first call date at the call price rather than held to the stated maturity date.
The Yield Order for Discount and Premium Bonds
The examination tests the relationships among these four yields more frequently than it tests the calculations themselves. The ordering follows directly from the logic of how discounts and premiums affect total return.
For a bond trading at a discount, the correct ascending order of yields from lowest to highest is: nominal yield, current yield, yield to maturity, yield to call. The discount adds to the investor's return. The yield to maturity exceeds the current yield because it includes the annualised capital gain from buying below par. The yield to call exceeds the yield to maturity for a discount bond because the gain is earned faster if the bond is called early, producing a higher annualised return over the shorter period.
For a bond trading at a premium, the correct descending order of yields from highest to lowest is: nominal yield, current yield, yield to maturity, yield to call. The premium reduces the investor's return. The current yield is below the coupon rate because the fixed coupon is divided by a price above par. The yield to maturity is below current yield because it includes the annualised capital loss from paying above par and receiving only par at maturity. The yield to call is the lowest of all because the premium loss is suffered over the shortest period, producing the lowest annualised return.
When a bond trades at par, all four yields are equal to each other and to the coupon rate. This is the definition of a bond at par: the coupon rate and market yield are in equilibrium.
Zero Coupon Bonds — The Coupon Rate of Zero
A zero coupon bond carries a coupon rate of zero and makes no periodic interest payments. Instead, it is issued at a deep discount to par value and matures at par, with the entire return delivered as a single capital gain at maturity. A ten-year zero coupon bond with a par value of one thousand dollars might be issued for approximately six hundred and fourteen dollars if market yields are five percent, with the investor receiving one thousand dollars at maturity and the difference of three hundred and eighty-six dollars representing ten years of compounded interest.
The zero coupon bond has the highest duration of any bond at a given maturity because all cash flows arrive at the single maturity date, creating maximum sensitivity to interest rate changes. For this reason, zero coupon bonds are used by investors seeking precise duration-matching for liability management purposes and by institutions hedging long-duration obligations such as pension liabilities.
Even though zero coupon bonds make no actual cash interest payments, the IRS requires investors holding them in taxable accounts to recognise the annual accreted discount as ordinary interest income each year under the original issue discount rules of the Internal Revenue Code. This phantom income tax liability — paying tax on income not yet received in cash — makes zero coupon bonds most suitable for tax-deferred accounts such as individual retirement accounts, where the annual OID income recognition does not create a current tax obligation.
Floating Rate Bonds and the Contrast with Fixed Coupons
Most bonds carry fixed coupon rates, but floating rate bonds — also called variable rate bonds or adjustable rate bonds — have coupon rates that reset periodically based on a specified market interest rate benchmark plus a fixed spread.
A floating rate note might pay a coupon equal to the Secured Overnight Financing Rate plus one hundred basis points, resetting quarterly. As market short-term rates rise, the coupon rises proportionally, allowing the bond to continue trading close to par because the coupon adjusts to reflect current market conditions. As market rates fall, the coupon declines. This floating mechanism eliminates most interest rate risk for the investor, because the coupon payment adjusts to market yields rather than remaining fixed while the price adjusts. The tradeoff is that the investor does not benefit from rising bond prices when rates fall, since the coupon decline keeps the price near par rather than allowing it to appreciate.
The distinction between fixed and floating coupon structures is examination-relevant because the two behave very differently in rising and falling interest rate environments, creating different suitability profiles and different analytical requirements.
Variable Rate Demand Obligations in Municipal Markets
In the municipal bond market, variable rate demand obligations carry floating coupon rates that reset frequently, typically weekly, and include a put feature that allows the bondholder to demand repurchase of the bond at par on each reset date. The combination of floating rate and embedded put effectively eliminates interest rate risk and credit risk exposure beyond the next reset period, making variable rate demand obligations function economically like money market instruments despite their long nominal maturities. They are widely held in tax-exempt money market funds for this reason.
Coupon Rate Disclosure and Confirmation Requirements
Under FINRA rules governing customer confirmations, every bond transaction confirmation must disclose the bond's coupon rate to the customer. FINRA Rule 2232 requires that trade confirmations for fixed income transactions include the interest rate of the security, expressed as the coupon rate. This disclosure is mandatory regardless of whether the transaction occurs in the primary market at issuance or in the secondary market at whatever price the bond has reached. The coupon rate disclosure allows the customer to calculate the expected annual dollar income from the position and to understand the income component of their investment independent of the current market price.
Examination Relevance and Key Takeaways
The coupon rate is tested on the SIE, Series 7, and Series 65 examinations in the context of bond yield calculations, yield relationships, bond pricing, interest rate risk, and zero coupon bonds. Candidates must know the four yield measures and their correct ordering for discount and premium bonds, be able to calculate current yield from the coupon and market price, and understand the distinction between the fixed coupon rate and the market-driven yields that change continuously.
The core points to retain are these: the coupon rate is the fixed annual interest rate stated in the bond indenture at issuance, expressed as a percentage of par value, and is also called the nominal rate, stated rate, or contract rate; the annual dollar coupon equals the coupon rate multiplied by par value and never changes regardless of market price; the coupon rate equals the nominal yield and is the only yield measure that remains constant throughout the bond's life; for a bond trading at a discount, the yield order from lowest to highest is nominal yield, current yield, yield to maturity, and yield to call; for a bond trading at a premium, the yield order from highest to lowest is nominal yield, current yield, yield to maturity, and yield to call; when a bond trades at par all four yields are equal; zero coupon bonds carry a coupon rate of zero, are issued at a discount and mature at par, have the highest duration of any bond at a given maturity, and require annual OID income recognition in taxable accounts even though no cash interest is paid; floating rate bonds have coupon rates that reset periodically based on a benchmark rate, eliminating most interest rate risk by keeping the coupon aligned with market yields; and FINRA Rule 2232 requires that the coupon rate be disclosed on every fixed income trade confirmation.
