When bond investors purchase a fixed rate bond from a borrower, they receive a locked-in interest rate through the life of the bond. The borrower makes regular interest payments to investors based on these interest rates, usually twice per year until the bond reaches maturity.
Note: Fixed rate serial bonds can have different coupons for bonds that mature on different dates.
The interest rate on the bond is known as its coupon and is expressed as a percentage of the bond’s face value. The term “coupon” dates back to a time when bond investors would receive physical coupons that they’d clip on interest payment dates and either mail in to the trustee or physically bring to the bank to receive their interest payments.
There’s often a direct correlation between a bond’s coupon and its risk level. High-yield bonds, often known as junk bonds, have a higher coupon rate to compensate for the additional risk of default an investor will have to accept.
Other factors that may affect a bond’s coupon include the term of the bond, the prevailing interest rates at the time, and any unique features the bond may have.
Example:
Suppose a bond has a face value of $1,000 and an annual interest rate (i.e., coupon) of 6.00%. If the bond pays interest semi-annually, twice a year, each bond investor will receive an interest payment for half of the total annual interest of $30 for a total annual interest amount of $60.
The bond investor can either reinvest the bond’s interest payment or use the interest payment as a source of income.
What’s important here?
A bond’s coupon is one of the factors investors will consider when deciding whether to buy a particular bond. The higher the bond coupon, the greater the source of income it can provide in the future for an investor.
