What a Bond Coupon Is and Why It Is Called That
For first time bond investors, it is not uncommon to hear your broker or other investors refer to the the interest income you receive as a "bond coupon". For example, a $100,000 bond that pays 5% interest, or $5,000 per annum, would be said to have a "5% coupon".
For those who are new or inexperienced and don’t know much about the history of the stock market or the bond market, this may seem confusing and a bit odd. There's actually an interesting story behind the terminology employed; why the phrase "bond coupon" has survived into the 21st century.
The Origin of Bond Coupons
In the days before computers automated and simplified much of the financial world, investors who bought bonds were given physical, engraved certificates; beautiful works of art that often involved commissioning talented engravers and artists to incorporate aspects of the firm's history or operations into the imagery.
He or she would then go lock those bond certificates in a safe deposit box or otherwise secure them some place where they couldn't be stolen or discovered. It was vitally important to keep the bonds safe from the outside world because the bond certificate served as proof that the investor had lent money to the bond issuer; that they were entitled to receive their principal plus interest.
Attached to each of those engraved bonds was a series of bond coupons. Each bond coupon had a date on it. Twice a year (as is customary in the United States as most bonds in this country have historically paid interest semi-annually), when the interest was due on the bond, the investor would go down to the bank, open the safe deposit box, and physically clip the appropriate bond coupon with the current date. He or she would take the coupon and deposit it, just like cash, into their bank account or mail it into the company to get a check, depending on the terms and the circumstances.
On the maturity date, when the bond principal was due, the bondholder would send their certificate back to the issuer who would then cancel it and return the certificate's par value back to the investor. The bond issue was then retired and the investor would have to figure out what he or she wanted to do with the money as there were no more payments coming their way.
If the bond issue wasn't able to make a coupon payment or repay the principal at maturity, the bond was said to go into default. In most cases, this would lead to bankruptcy and the creditors seizing whatever collateral they were guaranteed by the bond indenture, which is the contract governing the loan.
How Bond Coupons Work Today
The mechanics of investing in a bond is a bit different today due to the aforementioned technological advancements. If you were to acquire a newly issued bond through a brokerage account, the broker would take your cash then deposit the bond into your account, where it would sit alongside your stocks, mutual funds, and other securities. You'd see the bond interest get directly deposited into your account regularly without having to do a thing; no bond coupon clipping, no need to keep a bond certificate in a safe deposit box.
In the case of secondary issue bonds (bonds that were originally bought by an investor but sold to another investor prior to maturity), the acquisition price to the new investor is very likely to be different than the maturity value of the bond.
This, combined with any call provisions that allow the bond to be redeemed early, mean that the bond coupon will be different than the yield-to-maturity (the effective interest rate the investor will earn if he or she holds the bonds until it matures) or the yield-to-worst (the worst-case interest rate the investor will earn in the event of an unfavorable call or other situation).
During a low interest rate environment, any time you acquire older bonds that have higher bond coupons, you will actually pay more than the bond's maturity value, leading to a guaranteed loss on the principal repayment portion that, when offset by the higher bond coupon rate results in an effective interest rate that is comparable to those being newly issued at the time.
Some Bonds Are Known as "Zero Coupon" Bonds
Some bonds are known as "zero coupon" bonds, which might seem confusing. Zero coupon bonds are bonds that don't actually pay cash interest throughout the life of the bond but, instead, are issued at a discount to their maturity value. The specific discount is calculated to provide a specific rate of return by maturity when the bonds are supposed to be redeemed for their full face value.
Zero coupon bonds are generally more sensitive to interest rate risk and, worse, you have to pay income tax on the imputed interest you are theoretically receiving throughout the life of the bond rather than at the end of the period when you actually receive it in the form of a higher maturity value, which can lead to cash flow issues if you have a substantially fixed income portfolio of such holdings.