What is a coupon?
This is the interest rate payable by the borrower on the face value of the bond and is expressed as a percentage of the face value. If a bond is quoted as having a 10% coupon and a face value of £1,000, it means that it will pay £100 per annum (calculation: £1,000 X 10/100 = £100).
It is called a coupon because in the past there used to be physical coupons attached to the bond documentation that the bond holder tore-off and presented to redeem interest. Nowadays this is managed electronically. Bonds pay interest periodically which could be monthly quarterly, semi-annually or annually.
There are different categories of coupons:
- For most bonds, the coupon rate is a fixed percentage of the face value and the bond is described as a fixed rate bond. This indicates that the same coupon will be paid throughout the life of a bond. This is the origin of the terms “fixed interest” or “fixed income” to describe bonds.
- It is also possible to have bonds with a variable coupon rate known as floating rate bonds. A floating rate bond’s coupon resets periodically with reference to a given index and a constant premium or discount to the index rate. For example, the coupon of a floating rate bond described as 3 month LIBOR + 50bp, will be set to the prevailing 3 month LIBOR rate plus 0.5% every quarter. LIBOR is the London Interbank Offered Rate and is the interest rate at which banks are able to borrow from one another
- While not common, zero coupon bonds may also be issued. These bonds pay no interest and generally trade at a discount to face value.
The principal use of zero-coupon bonds is for modelling purposes: A bond can be viewed as a series of single cash flows and each of these can be viewed as a zero-coupon bond. The representation of a bond as a series of zero-coupon bonds helps with the comparison of the yield of one bond to another.
The payment of coupons also serves other purposes:
- The coupon obliges the issuer make a payment to bond holders. The ability to make this payment provides bond holders with a test of the issuer’s solvency and liquidity.
- The coupon reflects prevailing market conditions at the point of issue, in particular the expected liquidity of the bond and the expected credit quality of the issuer. A higher coupon normally reflects lower liquidity or credit quality.