Understanding the Relationship Between Coupon Rates and Bond Prices

How should the fixed income portfolio manager go about explaining the relationship between coupon rates and bond prices? Why do the coupon rates for the various bonds vary so much?

Before explaining the relationship between coupon rates and bond prices, we should understand what these concepts mean. A bond is a security or debt investment through a borrowing arrangement by which an investor loans money to an entity, which borrows the funds for a defined period of time at an interest rate. This interest rate, the regular return the investor who buys the bonds gets, is also called the coupon rate. Depending on the nature of these coupon rates, the expected return can vary because coupon rates are susceptible to fluctuations in interest rates.

The coupon rates and bond prices have an inverse relationship, meaning that when a coupon rate increases, the bond prices decrease and vice versa. For example, bonds with low ratings need to offer higher coupon rates to compensate investors for assuming additional risks.

Coupon rates vary so much because of two main reasons. First, due to changes in market interests as coupon rates fluctuate based on general market conditions. Second, due to changes in the ratings that represent the risk a bond entails (creditworthiness of the issuer), different investments have different risks, but also the investments with a longer maturity have higher risks, and therefore higher coupon rates.