What Is a Bond Coupon?

The Origins of Bond Coupons and How They Got Their Name

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"Bond coupon" is a term for interest payments that are made on a bond. It survives and is still used even though technology has made the actual coupons obsolete.

First-time bond investors who don't know much about the history of the stock market or the bond market can be confused when they hear interest income referred to as a bond coupon. Learn where the term "bond coupon" comes from and how it affects your investments today.

Key Takeaways

  • "Bond coupons" is a term that's used to refer to physical coupons. These coupons could be redeemed for cash.
  • The term is another way of referring to a bond's interest payment in 2022 and when it will be due.
  • The bond coupon may not match the actual interest payments on the secondary market. Ups and downs in bond price will change the interest payments.
  • Zero-coupon bonds don't pay interest. They instead mature to a value greater than the principal investment.

The Origin of Bond Coupons

Investors who bought bonds were given physical, engraved certificates before computers simplified much of the financial world. These certificates served as proof that you'd lent money to a bond issuer. You were entitled to receive the principal plus interest.

Attached to each engraved bond was a series of bond coupons. Each coupon had a date on it. Investors would physically clip the bond coupons with the current date twice a year when the interest was due. They would take the coupon and deposit it, just like cash, into a bank account. Or they would mail it in to get a check, depending on the terms and the circumstances.

A bondholder would send the certificate back to the issuer on the maturity date when the bond principal was due. They would then cancel it. They would return the certificate's par value back to the investor. The bond issue was then retired.

Note

Bond certificates were often works of art. The bond issuer would use talented engravers and artists to convey aspects of the firm's history or operations.

The bond was said to go into default if a bond issuer wasn't able to make a coupon payment or repay the principal at maturity. This would lead to bankruptcy in most cases. The creditors would seize whatever collateral they were guaranteed by the bond indenture, which is the contract that governs the loan.

How Bond Coupons Work Today

Technology has changed the process of investing in a bond. The need for paper coupons is no more. But the term is still used. A bond's coupon refers to the amount of interest due and when it will be paid. A $100,000 bond with a 5% coupon pays 5% interest.

The broker takes your payment and deposits the bond into your account when you invest in a newly issued bond through a brokerage account. There it sits alongside your stocks, mutual funds, and other securities.

Interest is deposited directly into your account when it's due. You won't have to do a thing—no bond coupon clipping and no need to keep a paper bond certificate in a safe deposit box. The interest payment is called a coupon payment.

Note

"Coupon clipping" means collecting the interest payment from a bond.

The interest payments will stay the same for bonds with a fixed coupon rate. Changes in the market won't affect them. Interest payments are periodically adjusted to align with market rates if a bond has a floating coupon rate.

Secondary-Issue Bonds

Bonds sold from one investor to another before they reach maturity are known as secondary-issue bonds. They often have an acquisition price that differs from the maturity value of the bond.

This means a bond coupon can differ from the interest rate you'll earn by holding it until it matures, in the event of an unfavorable call or, in some other, cases when it's combined with any call provisions that allow a bond to be redeemed early.

Older bonds with higher bond coupons actually pay more than a bond's maturity value during times of low interest rates. This leads to a guaranteed loss on the principal repayment portion. But it's offset by the higher bond coupon rate. It results in an interest rate close to those being newly issued at the time.

Zero-Coupon Bonds

Zero-coupon bonds pay no cash interest. They're issued at a discount to their maturity value instead. The discount provides a cited rate of return by maturity when the bonds are supposed to be redeemed for their full face value.

Zero-coupon bonds tend to be more sensitive to interest rate risk. You have to pay income tax on the imputed interest you're theoretically receiving through the life of the bond, rather than at the end of the period when you actually receive it. This can negatively impact cash flow if you have a fixed-income portfolio of such holdings.

Article Sources

  1. Investor.gov. "Glossary: Coupon."

  2. Investor.gov. "Corporate Bonds."

  3. Office of Investor Education and Advocacy. "Zero Coupon Bond."