What Does A Bond Coupon Mean?

What Does A Bond Coupon Mean?

The bond market is a source of reliable long-term investments during periods of high interest rates. While the prices of bonds do fluctuate on the market, this is not the primary purpose of bond investments.

Bonds pay out an annual, biannual, or quarterly percentage of the initial investment, which is called a bond coupon. 

Bond coupons are fixed interest rate payments made by the issuer of the bond. The bond issuer may be the state treasury, local government entity, or a corporation. The coupon rate may differ greatly depending on the issuer and the risks associated with its operations. 

The coupon rate is the annual interest rate specified on the bond when it is issued, and it is used to calculate the amount of each coupon payment.

The term "coupon" comes from the historical practice of attaching physical coupons to paper bonds. Bondholders would clip these coupons and redeem them for their interest payments when they came due. This process is fully digital on the modern markets, but the term has remained unchanged. 

Types Of Bond Coupons And How They Work

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”. 

Key Takeaways From What Does A Bond Coupon Mean

  • Coupons are the payments made on the bond principal by the issuer to the bondholders
  • Coupons can vary greatly in terms of payment frequency and coupon rates
  • Rates and all other relevant information regarding a bond is included in the prospectus document 
  • Bond coupons are sensitive to the changes of interest rates and treasury bonds tend to have lower coupon rates than corporate bonds, due to the differences in risk exposure

FAQs On What Does A Bond Coupon Mean

Which bonds have high coupon rates?

Junk bonds, which are rated low by credit agencies, typically have high coupon rates to attract investors. However, they also carry a high degree of risk and defaults are not at all uncommon. 

Are bond coupons fixed?

Most bonds have a fixed coupon. However, this is not always the case and some bonds have variable rates, while others are tied to international benchmarks, such as the LIBOR, and adjust their rates as the benchmark moves. 

Is a bond coupon the same as yield?

The difference between the bond coupon and yield is that the coupon rate shows the stated return paid on the bond, while yield shows actual returns over a year.