Coupon Bond

Introduction

Coupon bonds are a fixed-income asset that pays the bondholder interest through periodic coupon payments. A coupon bond issuer borrows money from investors and offers to repay it with interest over a set period.

What are coupon bonds?

Coupon bonds are debt security issued by corporations or governments to raise funds.

They are called coupon bonds because they typically pay interest in the form of coupons, which are detachable pieces of paper attached to the bond certificate. The coupon rate is the interest rate paid to bondholders, usually fixed when the bond is issued.

How do coupon bonds work?

Coupon bonds are fixed-income assets that pay bondholders interest through periodic coupon payments. When a firm or government issues a coupon bond, it promises to pay the bondholder a special interest rate on its face value semi-annually or annually. The interest payments continue until the bond matures. Then the bondholder receives the face value of the bond. A few examples are given below-

• Issuance − Bonds are issued to investors when a firm or government wishes to borrow money. A bond is a legal contract between the debtor and the company that issued it.

• Interest − The debtor agrees to pay the issuer a specified interest rate (the coupon rate) on the face value of the bond (the principal), and the principal is repaid when the bond matures.

• Maturity − When the bond reaches maturity, the issuer repays the face value of the bond to the debtor. If the face value of the bond is $1,000, the bondholder will receive $1,000 at maturity.

• Bond prices − The price of a coupon bond is determined by the market demand for the bond. The increase in the market interest rates will decrease the value of the bond and vice versa.

• Risks − Investing in coupon bonds involves many risks, including interest rate, credit, inflation, and liquidity. Interest rate risk emerges when changes in interest rates affect the bond's value. Credit risk emerges when the bond's issuer fails to make payments. Inflation risk emerges when the purchasing power of the bond's future cash flows is eroded by inflation. Investors who cannot sell their bonds at fair market value face liquidity risk.

How are bonds priced?

A bond's price is the present value of its future cash flows, including periodic coupon payments and the face value upon maturity. The present value is determined using the current market interest rate. The return rate investors require to purchase the bond.

If the coupon rate exceeds the market rate, the bond will be offered at a premium to its face value. The bond will be discounted to its face value if the coupon rate is lower than the market interest rate.

Formula and computation of coupon bond

The formula for the present value of a coupon bond is as follows −

$\mathrm{PV\:=\:C1/\lgroup1+r\rgroup^\wedge\:1\:+C2/\lgroup1+r\rgroup^\wedge\:2+.......+Cn\:/\lgroup1\:+\:r\rgroup^\wedge\:n\:+\:FV\:/\lgroup1\:+r\:\rgroup^\wedge\:n}$

Where −

PV = present value of the bond

C = coupon payment

r = market interest rate

FV = face value of the bond

n = number of years until maturity

To compute the coupon bond price, you need to input the values for each variable into the formula to attain the present value of the bond. The resulting present value will be the price the bond would sell for in the market.

Examples of Coupon Bonds

Coupon bonds are a popular investment option that offers bondholders a fixed interest rate. Here are some examples of coupon bonds −

• Corporate bonds − These bonds are issued by companies to raise funds for their business operations. Examples of companies that issue corporate bonds include Apple, IBM, General Electric, and Ford. These bonds usually have a higher yield than government bonds but are said to be riskier.

• Government bonds − Governments raise money for various projects and programs. Examples of government bonds include US Treasury bonds, Japanese Government Bonds (JGBs), and UK Gilts. Government bonds are considered low- risk investments but offer lower yields than corporate bonds.

• Municipal bonds − Cities, countries, and states also issue bonds to finance projects such as schools, highways, and airports, known as municipal bonds. They are tax-exempt at the federal level and may also be tax-exempt at other levels. Some examples of municipal bonds include the New York City Municipal Water Finance Authority and the Puerto Rico Electric Power Authority.

• Zero-coupon bonds − These bonds do not pay periodic coupon payments but are issued at a discount to their face value and pay the full face value at maturity. Zero-coupon bonds are popular among investors who want to lock in a fixed rate of return for a specific period. Examples of zero-coupon bonds include US Treasury STRIPS and TIGRs (Treasury Investment Growth Receipts).

These are just a few examples of coupon bonds that investors can consider.

Conclusion

Coupon bonds are a popular investment option for those looking for fixed-income investments. They provide a consistent revenue stream through coupon payments, and their price is easily computed using a simple formula. Before investing in coupon bonds, investors should carefully analyze the issuer's creditworthiness and market interest rates.

FAQs

Q1. What is a coupon bond?

Ans. A coupon bond is a type of fixed-income security that pays interest to bondholders through periodic coupon payments.

Q2. How do coupon bonds work?

Ans. When a company/government issues a coupon bond, it agrees to pay the bondholder a fixed interest rate. It is calculated on the face value of the bond on a semi- annual or annual basis. The interest payments are made until the bond reaches maturity. By then, the face value of the bond is paid back to the bondholder.

Q3. How are coupon bonds priced?

Ans. The price of a coupon bond is the present value of its future cash flows, which includes the periodic coupon payments and the face value at maturity. The present value is calculated using the prevailing market interest rate.

Q4. What are the risks of investing in coupon bonds?

Ans. The risks of investing in coupon bonds include interest rate, credit risk, inflation risk, and liquidity risk, as the interest rate is market-variable.