"Bond coupon" is a term for the interest payments made on a bond. It survives as part of investment vernacular even though technology has made the actual coupons obsolete.
Hearing interest income referred to as a bond coupon can confuse first-time bond investors who don’t know much about the history of the stock market or the bond market. Learn where the term "bond coupon" comes from and how affects your investments today.
- "Bond coupons" used to refer to physical coupons that could be redeemed for cash by bondholders.
- Today, the term is another way of referring to a bond's interest payment and when it will be due.
- For those who trade bonds on the secondary market, the bond coupon may not match the actual interest payments because fluctuations in bond price will change the interest payments.
- Zero-coupon bonds don't pay interest and instead mature to a value greater than the principal investment.
The Origin of Bond Coupons
Before computers automated and simplified much of the financial world, investors who bought bonds were given physical, engraved certificates. These certificates served as proof that an investor had lent money to a bond issuer and that they were entitled to receive the principal plus interest.
Historically, bond certificates were often beautiful works of art that involved commissioning talented engravers and artists to incorporate aspects of a firm's history or operations into the imagery.
Attached to each engraved bond was a series of bond coupons, each one with a date on it. Twice a year, when interest was due, investors would physically clip the appropriate bond coupons with the current date.
They would take the coupon and deposit it, just like cash, into a bank account or mail it to the company to get a check—depending on the terms and the circumstances.
On the maturity date, when a bond principal was due, a bondholder would send the 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.
If a bond issuer 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
Today, technological advancements have changed the mechanics of investing in a bond, eliminating the need for paper coupons. But the term is still used in modern investing.
A bond's coupon refers to the amount of interest due and when it will be paid. For example, a $100,000 bond with a 5% coupon pays 5% interest.
If you acquire a newly issued bond through a brokerage account, the broker takes your payment and deposits the bond into your account, where it sits alongside your stocks, mutual funds, and other securities.
When interest is due, it is deposited directly into your account. You won't have to do a thing—no bond coupon clipping and no need to keep a bond certificate in a safe deposit box. This interest payment is called the coupon payment.
When someone refers to "coupon clipping" in the context of investing, this means collecting the interest payment from a bond.
For bonds with a fixed coupon rate, the interest payments will stay the same, regardless of changes in the market. For bonds with a floating coupon rate, interest payments are periodically adjusted to align with market rates.
Bonds sold from one investor to another prior to maturity, known as secondary-issue bonds, typically have an acquisition price different than the maturity value of the bond.
This, combined with any call provisions that allow a bond to be redeemed early, means a bond coupon can be different from the interest rate an investor will earn by holding a bond until it matures, in the event of an unfavorable call, or in some other situations.
During low-interest-rate environments, older bonds with higher bond coupons actually pay more than a bond's maturity value. This leads to a guaranteed loss on the principal repayment portion, but it is offset by the higher bond coupon rate, and it results in an effective interest rate comparable to those being newly issued at the time.
Zero-coupon bonds pay no cash interest; instead, they 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 you have to pay income tax on the imputed interest you theoretically are receiving throughout the life of the bond, rather than at the end of the period when you actually receive it. This negatively impacts cash flow if you have a substantially fixed-income portfolio of such holdings.