What is a Coupon in Finance, and How is a Coupon Payment Calculated?
Investors considering fixed-income investments to diversify portfolios or create guaranteed passive cash flow will hear terms like coupon payment, coupon rate, and nominal yield, but what do they mean? We will answer the coupon definition finance question, give you the coupon payment formula, and provide a coupon payment example.
What is a Coupon in Finance - Answered
What is the definition of coupon meaning in finance? A coupon is an annual interest paid on a bond. Investors receive a coupon payment, either annually or semi-annually, from issuance until maturity, if they hold the bond. Investors get the coupon rate, expressed as a percentage of the face value of the bond, and the coupon payments as a fixed value, irrelevant to changes in the bond price. While the initial coupon rate remains fixed, bond yields fluctuate.
How is a coupon payment calculated?
Investors must know how to calculate the coupon bond payment to understand coupon finance. The formula is simple to understand, as explained in the example below.
Coupon payment calculation example:
- Assume an entity issues a $500 bond with a coupon rate of 2.00%
- The annual coupon payment is $10
The coupon payment formula is:
Face value ($500) x Coupon rate (2.00%) = Coupon payment ($10)
A Coupon in Finance Explained with an Example
The name coupon comes from the original bonds known as bearer bonds, which had coupons stamped on the back of each certificate. The holder, or bearer of the certificate, would detach the coupon and redeem it for payment. Today, the term coupon remained, but most bonds are electronic.
Coupon payment example:
- An investor buys one $10,000 bond with a maturity of ten years, and a coupon rate of 2.50% paid semi-annually
- The investor will receive 20 (ten years x 2 semi-annual periods) $125 payments for a total of $2,500, irrelevant of changing market conditions
- With the final coupon payment, the investor will also receive the $10,000 initial investment back
Noteworthy:
- Investors who reinvest the semi-annual coupon payments into the bond will achieve a higher effective yield
- Zero-coupon bonds do not pay interest but reward investors with a higher principal return at maturity
- The coupon rate remains fixed at issuance, together with the coupon payment, but bond yields change with bond price fluctuations
A Coupon Bond Explained
An investor who buys a coupon bond will receive annual or semi-annual payments until the bond maturity, plus the principal amount with the final coupon payment.
Coupon Conclusion
Coupon bonds are ideal for retirement accounts and passive income generating portfolios, as the coupon payment remains fixed.
FAQs
What is the difference between coupon and yield?
The coupon rate is the rate a bond pays at issuance, but the bond yield changes with bond price fluctuations.
Why is it called a coupon payment?
The predecessor to bonds, bearer certificates, had detachable coupons printed in the back, which holders would present to redeem payment.