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Bond coupons are the returns on the bonds for investors. However, these coupon payments are not homogenous between different bonds and there are a number of different bonds by coupon type.
Rates may be tied to certain market benchmarks from central banks, while some bonds may not pay any coupon at all.
The different types of bonds in terms of coupon rates are:
- Fixed-Rate Coupon: This is the most common type of coupon rate. It is a set percentage of the bond's face value (par value), and it remains constant throughout the life of the bond. For example, a bond with a 5% fixed-rate coupon will pay 5% of its face value in interest annually or semi-annually until maturity
- Variable or Floating-Rate Coupon: Some bonds have coupon rates that are not fixed but instead adjust periodically based on a reference interest rate, such as the London Interbank Offered Rate (LIBOR) or the U.S. Treasury rate
- Zero-Coupon Bonds: Zero-coupon bonds do not make periodic interest payments like traditional bonds. Instead, they are sold at a discount to their face value, and the investor receives the face value of the bond at maturity. The difference between the purchase price and the face value represents the interest earned on the bond
- Step-Up Coupon Bonds: These bonds have coupon rates that increase over time. For example, a step-up bond might start with a 2% coupon rate for the first few years and then increase to 3% in subsequent years
- Variable-Reset Coupon Bonds: These bonds have coupon rates that reset at specific intervals, typically based on prevailing market conditions. The reset rate may be based on a fixed spread above a reference rate, such as the Treasury rate
- Inflation-Indexed Bonds: Some bonds, like U.S. Treasury Inflation-Protected Securities (TIPS), have coupon rates that are adjusted for inflation. The principal value of these bonds increases with inflation, which also affects the coupon payments
- Capped or Floored Coupon Bonds: These bonds have coupon rates with upper and lower limits. The coupon rate cannot exceed the cap or fall below the floor, providing a range within which the interest rate fluctuates
Coupon Rate Calculation
Calculating the coupon rate of a bond is a relatively simple process. The formula for calculating the coupon rate is as follows:
Coupon Rate = Annual Coupon Payment / Face Value Of The Bond X 100
However, calculating the coupon rate of an issued bond is generally not necessary, as this and other data is readily available in the bond prospectus document.
It is important to consider that bonds with variable coupon rates are not constant and this formula does not apply to them. The change in prevailing interest rates and any other benchmark, such as the LIBOR rate, can affect the coupon rate of the bond.
Coupon Stripping
Coupon stripping, also known as bond coupon stripping or zero-coupon bond creation, is a process that involves separating the interest payments (coupon payments) from a bond and selling them as individual securities.
Initially, a bond is issued with a fixed coupon rate, and it typically pays periodic interest payments to bondholders over its maturity. For example, a 10-year Treasury bond with a 3% annual coupon rate will make semi-annual interest payments to bondholders.
To create separate securities from the bond's interest payments, financial institutions or the U.S. The Treasury itself may use a process called book-entry stripping.
The bond's interest payments are separated into individual components, each representing a specific coupon payment.
These components are then sold as separate securities, often referred to as "strips" or "zero-coupon bonds”.
