What is a Coupon Bond?
A coupon bond is a type of bond that includes attached coupons and pays periodic (typically annual or semi-annual) interest payments 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 rates provide higher yields. Thus, coupon bonds are more lucrative to investors, though their value may vary over time.
In the past, coupon bonds were issued in the form of bearer certificates. It means that the physical possession of the certificate was proof of ownership. Coupons were printed on certificates and, at the due date, the coupon was detached from the certificate and presented for payment.
Nowadays, physical versions of these 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 only means 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 an 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 a $5 annual interest to investors on every bond purchased. After four years, on the bond’s maturity date, Apple will make its last coupon payment, as well as the face value of the bond.
Coupon Bond Pricing
Despite the bond’s relatively simple design, its pricing remains a crucial issue. Investors should know a lot about bond pricing because it provides them a maximum price that they are willing to pay for the bond. 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 in this type of bond are fixed and set over fixed time periods:
For more learning, CFI offers a wide range of courses on accounting, financial analysis, and financial modeling, including the Financial Modeling & Valuation Analyst (FMVA)™ certification program. To keep advancing your career, the following resources will be helpful: