Coupon
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What is a Coupon?
The coupon rate on a bond represents the annual interest rate. There are two types of interest rates: fixed and variable. From the date of issuance of the bond until the date of maturity, the coupon is payable every period. The coupon is paid regularly on fixed interest dates (e.g., annually, semi-annually, or quarterly). Bond coupons are expressed as percentages of the bond's nominal value. It is also possible to refer to the coupon as a nominal yield, but the nominal yield should not be confused with the bond yield (current yield).
Difference Between Coupon and Bond Yield
Bond yield refers to the actual interest rate on a bond. Since bonds can be traded before they mature, causing their market value to fluctuate, the actual yield (often called yield) generally differs from the coupon or nominal yield.
The Calculations of the Coupon and Bond Yield
Consider a bond with a price of CHF 100 and a fixed coupon of 2%. There are two payments per year (semi-annually). Each payment would be worth CHF 1 to the investor. In this example, the nominal yield, as well as the bond yield, are 2% per year.
Suppose the bond is traded at CHF 90 at a later date. The nominal yield (coupon yield) is still calculated on the basis of the nominal value of the bond and thus remains at 2%. The bond yield, however, increases. This example would result in a bond yield of 2.2% (CHF 2/CHF 90).
Fixed Interest and Floating Interest
The issuer benefits from a fixed interest rate by being able to calculate the amount of payments to the bond creditor (investor). In the event that market interest rates rise, the payments will not be affected. Alternatively, the issuer does not benefit from a reduction in interest rates.
In the case of a variable interest rate, the interest rate is adjusted at defined dates (to the current level of a reference interest rate). There is, however, a difference between the coupon rate and the reference rate. In general, an interest premium is charged, which varies according to the creditworthiness of the issuer and the maturity of the bond. The so-called "floater" bond is an example of a bond with a variable coupon. An investor may benefit from increases in interest rates (reference interest rate increases). It is difficult to predict how interest rates will develop in the future. Furthermore, the bond's price fluctuation is low, which is another advantage for investors. The downside of this is that price gains may be less favorable. Having a variable interest rate has the disadvantage of making it difficult to calculate the payment in advance.
The History of Coupon Bonds
The coupons on bond certificates used to be detachable. There was no registration requirement for bonds with coupons. Therefore, the bond certificate owner is the owner of the bond. To obtain the bond, the coupon must be detached from the bond certificate and presented. The majority of investors and issuers today maintain electronic records of bond ownership. In spite of this, the term "coupon" continues to be used to describe the nominal yield of a bond.
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