What is Coupon Bond?
Coupon bonds are a type of bond that pay fixed interest (coupons) at a predetermined frequency from the bond’s issue date to the bond’s maturity or transfer date. The holder of a coupon bond receives a periodic payment of the stipulated fixed interest rate, which is determined by multiplying the coupon rate by the bond’s nominal value and the period factor. For example, if you own a bond with a face value of $1,000 and an annual coupon rate of 5%, your annual interest payment will be $5.
Coupon Bonds were more prevalent in an era that was not dominated by computers. In the 1980s, a trend of selling the coupons of the coupon bond as separate securities, called strips, was started by some institutions. However, the procedure of investing in bonds has seen a sea change since the prevalence of using computers. You no more present hard copies of coupons to redeem your interest amount.
Coupon Bond Pricing
These bonds are relatively simple, but their price remains a key issue. If you are investing in these bonds, then you should know the pricing well so that you can reap the maximum benefit out of it. Knowing the pricing of these bonds tells them the maximum price that they will have to pay for the bond. The investors may need a higher rate of return on the bond if the probability rate is high by default. There is a formula to determine the price of coupon bonds:
- c = coupon rate
- i = interest rate
- n = number of payments
Terms Related to Coupon Bonds
These bonds are also known as bearer bonds. This name is derived from the fact that anyone who presents the coupon to the issuer is entitled to the interest payment whether or not the person is the owner of the bond. This feature of the coupon bond could lead to tax evasionsTax EvasionsTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. and frauds.
Some coupon bonds are known as ‘zero-coupon bondsZero-coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity..’ These are bonds that do not make cash payments of interests through the duration of the bond but are instead issued as discounts to the maturity value of the bonds. The specific discount value is calculated to provide a certain rate of return at maturity when the bond is set to be redeemed for its full face value.
Who should Invest in Coupon Bonds?
Investors make money from bearer bonds on their maturity. The interest is paid to them at the maturity of the bond. The time required to reach maturity depends on whether the bond is a long-term or short-term investment. Short-term bearer bonds are known as bills. In case the coupon bond is for a long period, from fifteen to twenty years, then the investor gets paid their interest after a period of two decades.
These bonds are not a good option for someone looking for a steady flow of income. However, they are ideal for families who are looking into systematic investment plans. If you want a vacation home after your retirement, a coupon bond is a good option. Bearer bonds are also a good way of passing on wealth to your heir. A coupon bond is a good way of increasing your income over a period of time.
Coupon bonds are subjected to taxation in the US. Hence they can be held in a tax-deferred retirement account in order to save investors on paying taxes on the future income. On top of this, if the US government entity—state or local issues a coupon bond, it is exempted from all taxesExempted From All TaxesTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only..
This has been a guide to what Coupon Bond is and its definition. Here we discuss how does Coupon Bonds work, its Pricing formula, and who should consider investing in coupon bonds. You can learn more about Fixed Income from the following articles –