Explained: The concept of coupon bonds
Bonds are debt instruments issued by corporate entities such as companies and governmental institutions such as state government, central government, municipalities to raise funds for their projects. They have a maturity date on which the principal amount has to be paid back by the borrower. These bonds are not registered, so the bearer/holder of the bond is assumed to be the owner. This feature makes the instruments tradable on stock exchanges and in over the counter (OTC) markets.
Bondholders are creditors of the company or the government institution. They are paid a fixed interest rate which is specified on the bond. This interest rate is known as a coupon. It is also known as coupon rate, coupon per cent rate and nominal yield. A coupon can also be of floating or variable rate. The investors are paid coupons yearly till the bond matures.
It is calculated as:
Coupon rate= Total annual payment made by the borrower/ face value of the bond.
Though bondholders usually receive coupon payments, there is a specific type of bond which does not pay coupons and is known as zero-coupon bonds. It is also called a pure discount bond or deep discount bond.
Calculation of a zero-coupon bond is:
Price of the bond= Face value of the bond/ (1+R) ^N (assuming interest is calculated annually)
R= Rate of interest
N= Number of years to maturity
But how can the investors benefit?
At the time of issuance, these bonds are purchased at a discount, which is at a price less than the face value of the coupon. Whereas, at the time of maturity, the investor redeems the bond at its face value. The difference between the issue price and the face value of the bonds is the profit that the investor makes.
The no coupon payment feature in this type of bond results in the elimination of re-investment risk. However, the bond faces interest rate risk due to the possibility of value reduction that arises from interest rate fluctuations.