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- Relative Risk Reduction Formula
What is Coupon Bond?
Coupon bonds have fairly small detachable coupons which entitle the inventors to interest payments from the lender. For example, if you have a bond of 1000 USD and you are given the interest of 5%, then you have a 5% coupon rate. Each coupon has a date on it and on that particular date, the borrower is supposed to physically attach the coupon to the bond certificate. Coupons were treated like cash.
How does Coupon Bond Work?
These bonds were more prevalent in the 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.
- If you were to buy a newly issued bond through a brokerage account, the broker would get the cash from you and then deposit the bond into your account. In such cases, the interest from your bond will directly be deposited in your account along with your mutual funds and securities.
- These bonds are required in the second issue of bonds. Secondary bonds are those that were originally bought by an investor and then sold to another investor prior to maturity. In such cases, the acquisition price to the new investor is very different from that of the maturity value of the bond.
- In such cases and also if there is provision for the bond to be redeemed early the coupon bonds will be different from the yield-to-maturity (the effective interest rate that the investor will earn in case he or she waits till maturity) or yield-to-worst (the worst scenario interest rate that the investor will earn in case the bond is recalled before maturity).
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 bond. 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 evasions and frauds.
Some coupon bonds are known as ‘zero coupon bonds’. 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 their full face value.
Who should Invest in Coupon Bonds?
Investors make money from bearer bond 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, 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 taxes.
Hence it has been proven that coupon bonds can be defined as the absence of interest payments for investors. Hence if someone is looking for a long term investment in fixed income security then bearer bonds are a good option. For families saving for the future or parents saving for the higher education of their children, coupon bonds have proved to be ideal. Even for those who like to watch the market trend, investing in coupon bonds are a good option. Also, if you want to add variety to your portfolio, coupon bonds are a good option.
This has been a guide to what is Coupon Bond 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 –