Coupon payment

Definition

A coupon payment is the periodic interest payment made to bondholders during the life of a bond, typically expressed as a percentage of the bond's face value. These payments serve as an incentive for investors to purchase bonds, as they provide a predictable stream of income over the bond's term. Understanding coupon payments is essential for evaluating the yield and overall attractiveness of a bond investment.

5 Must Know Facts For Your Next Test

1. Coupon payments are usually made semiannually, but they can also be paid annually or quarterly depending on the bond's terms.
2. The coupon rate, which determines the amount of each coupon payment, is fixed at the time of issuance and does not change throughout the life of the bond.
3. Investors often compare coupon payments to current market interest rates to determine if a bond is attractive relative to other investment options.
4. If interest rates rise after a bond is issued, existing bonds with lower coupon payments may sell at a discount in the secondary market.
5. Coupon payments are taxable as ordinary income for investors in many jurisdictions, affecting the net return on investment.

Review Questions

• How do coupon payments influence an investor's decision when purchasing bonds?
  • Coupon payments significantly impact an investor's decision-making by providing predictable income during the life of a bond. Investors often evaluate these payments against current interest rates to assess whether a bond is competitive in the market. A higher coupon payment may attract more investors, particularly if it exceeds prevailing rates, while lower payments might make a bond less appealing.
• Discuss how changes in market interest rates affect the attractiveness of bonds with fixed coupon payments.
  • When market interest rates rise, newly issued bonds tend to offer higher coupon payments, making existing bonds with fixed lower payments less attractive. This situation can lead to existing bonds trading at a discount in the secondary market. Conversely, if interest rates fall, existing bonds with fixed higher coupon payments become more desirable, potentially allowing them to trade at a premium.
• Evaluate the impact of tax treatment on investor returns from coupon payments compared to other forms of income.
  • The tax treatment of coupon payments can significantly influence investor returns, as these payments are often taxed as ordinary income. This taxation can reduce the effective yield compared to capital gains from other investments, which may be taxed at a lower rate. Therefore, investors must consider their tax situation when evaluating bonds based on their coupon payments relative to potential after-tax returns from other assets.

Related terms

Yield to Maturity (YTM): The total return anticipated on a bond if it is held until maturity, taking into account all coupon payments and the difference between the purchase price and face value.

Face Value: The nominal value of a bond that is paid back to the bondholder at maturity, also known as par value.

Current Yield: A measure of the income generated by a bond as a percentage of its current market price, calculated by dividing the annual coupon payment by the current market price.