Question

in 500 words or more, explain the following two concepts: -The coupon rate depends on the risk characteristics of the bond when issued. -The impact of inflation rate on interest rates.

Answer 1

Let's handle the two statements one by one:

The coupon rate depends on the risk characteristics of the bond when issued.

The coupon rate for any bond is the market rate of interest that will be paid for any bond. Let's understand this thing in really simple terms, if you have two options of investing a $1000, out of which one option is safe secure government bond that will pay you an interest of 3% and other one is corporate bond from a corporation.

What would be your expectation of interest rate of the corporation bond?

Obviously, it will be higher than the government rate of 3%, as there is more risk of non payment in the corporate bond against the safe secure government bond. Therefore, the investor would demand a certain amount of risk premium in the coupon rate for the additional amount of risk that he bears.

The more risk the investor perceives, will make him demand more of risk premium for coupon rate.

Impact of Inflation rate on interest rates

Investing in bond is same as investing in certain number of future cash flows. Therefore, in cases, where there is expected that there will be inflation in the future. The value of future cash flows will reduce and will give less real return to the investor.

This also impacts the yield of the investor - as the higher rate of expected inflation will reduce the yield of the investor from the investment in the bond. This will make the investor demand higher amount of coupon rate to compensate for the reduced yield in the returns.

In simple words, we can say that higher level inflation will result in reduced yield and reduced purchasing power of the cash flows that will lead to high coupon rate to be demanded by the investor.