What a Bond Coupon Is and Why It Is Called That
"Bond coupon" survives as part of investment vernacular even though technology has made the actual coupons obsolete. References to interest income 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.
For example, stating that a $100,000 bond has a 5% coupon simply means that it pays 5% interest, or $5,000 per annum. This may seem a bit odd, but the story behind the terminology involves actual paper coupons.
The Origin of Bond Coupons
Before computers automated and simplified much of the financial world, investors who bought bonds were given physical, engraved certificates. Investors then would lock those certificates in a safe deposit box or otherwise secure them where they couldn't be stolen or discovered. It was vitally important to keep the bonds safe from the outside world because a bond certificate 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 often were 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 go to the bank, open the safe deposit box, and 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 then would 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 decide what to do with the money as there were no more payments due.
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
Technological advancements changed the mechanics of investing in a bond. If you acquire a newly issued bond through a brokerage account, the broker takes your cash then deposit the bond into your account, where it sits alongside your stocks, mutual funds, and other securities.
Bond interest is directly deposited into your account regularly without having to do a thing—no bond coupon clipping and no need to keep a bond certificate in a safe deposit box.
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 than the interest rate an investor will earn by holding a bond until it matures or in the event of an unfavorable call or other situation.
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 is offset by the higher bond coupon rate and results in an effective interest rate comparable to those being newly issued at the time.
Zero-coupon bonds pay no cash interest 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 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.