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:

  1. 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.
  1. 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
  1. 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:

  1. 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.
  1. 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.