Coupon Cap

A Coupon Cap is a provision in a debt security, most commonly a floating-rate note (FRN), that sets the maximum interest rate the security can pay. Think of it as a “ceiling” on the interest payments, or coupons, you can receive. The interest rate on an FRN isn't fixed; it adjusts periodically based on a benchmark rate, such as the SOFR (Secured Overnight Financing Rate). A cap ensures that even if this benchmark rate skyrockets, the issuer's interest expense won't go above a pre-defined, manageable limit. For you, the investor, this means your potential return is limited. Why would anyone agree to this? In exchange for accepting this capped upside, a bond with a coupon cap typically offers a slightly higher initial interest rate or a more favorable spread over its benchmark. The issuer is essentially paying you a small premium for protection against runaway interest rate costs.

Imagine you're renting out a property where the monthly rent goes up and down with the local market rate. A coupon cap is like signing a contract that says, “No matter how hot the rental market gets, the rent will never go above €2,000 a month.” It protects the tenant (the bond issuer) from unaffordable payments. Let's look at a practical example. Suppose MacroCorp issues an FRN that pays an annual coupon of SOFR + 2%, but with a coupon cap of 7%.

• Scenario 1: Rates are low

If SOFR is 3%, the coupon paid to you is 3% + 2% = 5%. This is below the 7% cap, so you get the full 5%.

• Scenario 2: Rates are high

If SOFR jumps to 6%, the calculated coupon would be 6% + 2% = 8%. However, because of the 7% coupon cap, the interest payment is capped. You receive only 7%. You miss out on that extra 1% of potential return.

For a value investor, understanding a coupon cap isn't just about knowing the definition; it's about evaluating the trade-off. You're being asked to give up unlimited upside for a little something extra upfront. The crucial question is: Is it a good deal?

The primary risk you take on with a capped bond is opportunity cost. If interest rates climb past the cap, you're stuck holding an underperforming asset while newer bonds are being issued at much more attractive rates. This is a painful form of interest rate risk. Your reward for taking this risk is the slightly better yield you get from day one. A value investor must analyze whether this initial “sweetener” is adequate compensation for the capped potential. This requires forming an educated opinion on the future path of interest rates.

• If you believe rates are likely to remain stable or fall, a capped FRN might be a fantastic bargain. You collect the higher yield and the cap never becomes a factor.
• If you anticipate a period of high inflation and rising rates, that same capped FRN suddenly looks like a poor choice. The cap becomes a very real ceiling on your returns.

From the company's perspective, a cap is a brilliant risk management tool. It makes future interest expenses predictable and protects its cash flow from being wrecked by a sudden rate spike. This enhanced financial stability can make the company a safer credit risk, which is ultimately a good thing for any bondholder.

A coupon cap is part of a family of features designed to manage interest rate volatility. Its two closest relatives are floors and collars.

• A coupon floor is the exact opposite of a cap. It sets a minimum guaranteed interest rate on a floating-rate note. This protects you, the investor, from seeing your income evaporate if interest rates plummet towards zero.
• A coupon collar is simply a bond that has both a coupon cap and a coupon floor. The interest rate is “collared,” meaning it's trapped within a predefined range. This creates a predictable band of outcomes that offers a degree of comfort to both the issuer (protected by the cap) and the investor (protected by the floor).