A coupon rate is the yield paid by a fixed-income security; a fixed-income security's coupon rate is simply just the annual coupon payments paid by the issuer relative to the bond's face or par value. The coupon rate is the yield the bond paid on its issue date. This yield changes as the value of the bond changes, thus giving the bond's yield to maturity.
A bond's coupon rate can be calculated by dividing the sum of the security's annual coupon payments and dividing them by the bond's par value.
All else held equal, bonds with higher coupon rates are more desirable for investors than those with lower coupon rates. The coupon rate is the interest rate paid on a bond by its issuer for the term of the security. The term "coupon" is derived from the historical use of actual coupons for periodic interest payment collections. Once set at the issuance date, a bond's coupon rate remains unchanged and holders of the bond receive fixed interest payments at a predetermined time frequency.
A bond issuer decides on the coupon rate based on prevalent market interest rates, among others, at the time of the issuance. Market interest rates change over time and as they move higher or lower than a bond's coupon rate, the value of the bond increases or decreases, respectively. Changing market interest rates affect bond investment results. Because bonds can be traded before they mature, causing their market value to fluctuate, the current yield often referred to simply as the yield will usually diverge from the bond's coupon or nominal yield.
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The coupon rate, however, does not change, since it is a function of the annual payments and the face value , both of which are constant. The current yield is used to calculate other metrics, such as the yield to maturity and the yield to worst. The term "coupon" originally refers to actual detachable coupons affixed to bond certificates. Bonds with coupons, known as coupon bonds or bearer bonds , are not registered, meaning that possession of them constitutes ownership.
To collect an interest payment, the investor has to present the physical coupon. Bearer bonds were once common.
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While they still exist, they have fallen out of favor for two reasons. First, an investor whose bond is lost, stolen or damaged has functionally no recourse or hope of regaining his investment. Second, the anonymity of bearer bonds has proven attractive to money launderers. It is a hybrid security with debt- and equity-like features. Convertible bonds are most often issued by companies with a low credit rating and high growth potential.
Differences and Definitions of Stocks and Bonds
Convertible bonds are also considered debt security because the companies agree to give fixed or floating interest rate as they do in common bonds for the funds of investor. To compensate for having additional value through the option to convert the bond to stock, a convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity.
These properties lead naturally to the idea of convertible arbitrage , where a long position in the convertible bond is balanced by a short position in the underlying equity. From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.
Convertible notes are also a frequent vehicle for seed investing in startup companies , as a form of debt that converts to equity in a future investing round.
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Underwriters have been quite innovative and provided several variations of the initial convertible structure. Although no clear classification formally exists in the financial market it is possible to segment the convertible universe into the following sub-types:. Any convertible bond structure, on top of its type, would bear a certain range of additional features as defined in its issuance prospectus:.
Due to their relative complexity, convertible bond investors could refer to the following terms while describing convertible bonds:. The global convertible bond market is relatively small, with about bn USD as of Jan , excluding synthetics , as a comparison the straight corporate bond market would be about 14, bn USD. Among those bn, about bn USD are "Vanilla" convertible bonds, the largest sub-segment of the asset class. Convertibles are not spread equally and some slight differences exist between the different regional markets:.
The splits between those investors differ across the regions: Globally the split is about balanced between the two categories. In theory, the market price of a convertible debenture should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares. In-the-money CB's are considered as being within Area of Equity the right hand side of the diagram. Out-the-money CB's are considered as being within Area of Debt the left hand side of the diagram. From a valuation perspective, a convertible bond consists of two assets: Valuing a convertible requires an assumption of.
Using the market price of the convertible, one can determine the implied volatility using the assumed spread or implied spread using the assumed volatility.