The “coupon bond” is a term used to refer to the interest payments that are made on the bond. Although technology has made physical coupons outdated, the term still persists and is used.
The Origin of Coupon Bonds and How They Got Their Name
Investors who bought bonds used to receive certificates engraved on paper before technology greatly simplified the financial world. These certificates served as proof that you had lent money to the bond issuer. You were entitled to receive both the principal and the interest.
Attached to each bond was a series of coupon bonds. Each coupon had a specific date. Investors would cut the coupon bonds on the current date twice a year when interest was due. They would take the coupon and deposit it into a bank account, just like paper cash, or send it in for a check, depending on the terms and conditions.
The bondholder had to return the certificate to the issuer on the maturity date when the principal of the bond was due. It would then be canceled. The nominal value of the certificate was returned to the investor. The issuance of the bond is considered retired afterward.
Note: Bond certificates were often works of art. The issuer would use engravers and talented artists to convey aspects of the company’s history or operations.
How Coupon Bonds Work Today
Technology has transformed the process of investing in bonds. There is no longer a need for paper coupons. However, the term is still used. The coupon bond refers to the amount of interest due and the payment date. The broker pays the amount due and deposits the bond in your account when you invest in a newly issued bond through a brokerage account. The bond sits alongside your stocks, mutual funds, and other securities.
The interest is credited directly to your account when due. You won’t need to do anything – no cutting coupon bonds or keeping a physical bond certificate in a safe deposit box. The interest payment is referred to as the coupon payment.
Note: “Cutting the coupon” means collecting the interest payment from the bond.
Interest payments remain fixed for bonds with a fixed interest rate. Changes in the market do not affect them. Interest payments are periodically adjusted to align with market rates if the bond has a floating interest rate.
Secondary Market Bonds
Bonds that are sold from one investor to another before they reach maturity are known as secondary market bonds. They often have an acquisition price that differs from the bond’s maturity value.
This means that the coupon bond can differ from the interest rate you will earn if you hold it until maturity, in the case of an adverse call or in some other cases where they are combined with any call provisions allowing for the bond to be redeemed early.
Older bonds with higher coupons actually pay more than the maturity value for bonds during periods of low-interest rates. This leads to a guaranteed loss in part of the capital recovery. But it is offset by the higher interest rate of the coupon bond. This results in an interest rate close to those being newly issued at that time.
Bonds Without Coupons
Bonds without coupons do not pay cash interest. Instead, they are issued at a discount to their value at maturity. The discount provides an advertised yield by maturity when the bonds are redeemed at their full nominal value.
Bonds without coupons tend to be more sensitive to interest rate risk. You must pay income tax on the imputed interest that you theoretically receive over 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 consisting of these securities.
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Sources:
– Investor.gov. “Glossary: Coupon.”
– Investor.gov. “Corporate Bonds.”
– Office of Investor Education and Advocacy. “Zero Coupon Bond.”
Source: https://www.thebalancemoney.com/what-is-a-bond-coupon-and-how-did-it-get-its-name-357374
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