A debt with coupons attached that pay annual or semi-annual interest payments and par value at maturity
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A coupon bond is a type of bond that includes attached coupons and pays periodic (typically annual or semi-annual) interest payments during its lifetime and its par value at maturity. These bonds come with a coupon rate, which refers to the bond’s yield at the date of issuance. Bonds that have higher coupon rates offer investors higher yields on their investment.
In the past, such bonds were issued in the form of bearer certificates. This means that the physical possession of the certificate was sufficient proof of ownership. No records of the original or any subsequent buyer of the bond was retained by the issuer. They came to be known as “bearer bonds” because anyone bearing the appropriate coupon could present it to the issuer’s agent and receive the interest payment. The coupons were printed on the bond, from which they could be detached and presented for payment.
There were both positive and negative aspects to this anonymity of buyers. First, the buyer could remain anonymous if they so desired. Second, the detachable coupons made collecting the interest payments very simple. On the downside, however, these bonds with no purchase records presented large opportunities for fraud and were tempting targets for thieves.
Nowadays, physical versions of bonds are uncommon since most bonds are created electronically and do not come with physical certificates. Nevertheless, the term “coupon” is still used, but it merely refers to the bond’s nominal yield.
How Does a Coupon Bond Work?
Upon the issuance of the bond, a coupon rate on the bond’s face value is specified. The issuer of the bond agrees to make annual or semi-annual interest payments equal to the coupon rate to investors. These payments are made until the bond’s maturity.
Let’s imagine that Apple Inc. issued a new four-year bond with a face value of $100 and an annual coupon rate of 5% of the bond’s face value. In this case, Apple will pay $5 in annual interest to investors for every bond purchased. After four years, on the bond’s maturity date, Apple will make its last coupon payment. It will also pay the investor back the face value of the bond.
Despite the bond’s relatively simple design, its pricing remains a crucial issue. If there is a high probability of default, investors may require a higher rate of return on the bond.
Similar to the pricing of other types of bonds, the price of a coupon bond is determined by the present value formula. The formula is:
c = Coupon rate
i = Interest rate
n = number of payments
Also, the slightly modified formula of the present value of an ordinary annuity can be used as a shortcut for the formula above, since the payments on this type of bond are fixed and set over fixed time periods:
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