Coupon Rate vs. Interest Rates in Treasury Bond Investing.
June 21, 2024
Update.
if the interest rate is higher than the coupon rate, you will buy the bond at a discount, meaning you pay less than the bond's face value.
when the coupon rate is higher than the Interest rate, you pay a premium to acquire the bond's face value.
Friends,
When it comes to investing in treasury bonds, a common question arises: which is more important, the coupon rate or the interest rate? This article aims to clarify the distinction between the two and provide guidance on what should influence your investment decisions. We will examine two 20-year treasury bonds: one with a 15% coupon rate and another with an 18.5% coupon rate.
The coupon rate determines the cash flows from a bond based on its face value. For instance, if you purchase a bond with a face value of UGX 100 million and a coupon rate of 15%, you will receive 15% of UGX 100 million annually. However, it's crucial to understand that the face value of UGX 100 million does not necessarily reflect the amount you pay to acquire the bond.
On the other hand, the interest rate, also known as the yield rate, indicates the cost you will incur. It's essential to differentiate between the cost and the face value: the cost is the actual amount you pay, while the face value is the bond's value as issued by the Bank of Uganda. If the interest rate equals the coupon rate at the time of purchase, the cost of the bond will be the same as its face value. In other words, if you spend UGX 100 million to buy a treasury bond and the coupon rate is equal to the interest rate, you will receive a bond with a face value of UGX 100 million.
However, if the interest rate is higher than the coupon rate, you will buy the bond at a discount, meaning you pay less than the bond's face value. This was the case in a recent auction where the bond's coupon rate was 15%, but the interest rate was 17%, resulting in a 2% (200 basis points) increase over the coupon rate. Consequently, investors enjoyed a 12% discount rate because the interest rate was higher than the coupon rate.
Conversely, when the coupon rate is higher than the Interest rate, you pay a premium to acquire the bond's face value. For example, if you spend UGX 100 million, you might only receive a bond worth UGX 84 million in face value, meaning you have overpaid by UGX 16 million, which is not a profitable scenario.
Let's compare these two bonds on the secondary market:
Case 1:
A 20-year treasury bond with an 18.5% coupon rate is currently attracting an interest rate of 15.85%. If an investor spends UGX 100 million on this bond, they will only receive a face value of UGX 83 million. Despite receiving coupon payments at 18.5%, these are calculated on the UGX 83 million face value, not the UGX 100 million cost. Therefore, they will receive UGX 6.9 million net of tax every six months, totaling UGX 13.8 million annually.
Case 2:
Another 20-year treasury bond with a 15% coupon rate has an interest rate of 16.9% on the secondary market. An investor with UGX 100 million would receive a face value of UGX 104 million because the interest rate is higher than the coupon rate, indicating they are buying the bond at a discount. Their semi-annual coupon payments would be based on the UGX 104 million face value, resulting in UGX 7.06 million every six months, or UGX 14.13 million annually.
Comparative Analysis:
Two investors, each with UGX 100 million, made different choices. Investor A chose the bond with an 18.5% coupon rate but a lower interest rate of 15.85%, resulting in a face value of UGX 83 million and an annual return of UGX 13.8 million. Investor B opted for the 15% coupon bond with a higher interest rate of 16.9%, acquiring a face value of UGX 104.7 million and earning approximately UGX 14.13 million per year, which is UGX 300,000 more than Investor A.
When investing in treasury bonds, the interest or yield rate is what matters most. A bond with a high coupon rate but a very low yield rate may not be the best option when you can choose a bond with a lower coupon rate but a higher interest rate, as demonstrated above using current market data.
Thank you Mr Alex