What is a Coupon Bond? Meaning, Types and Example

A coupon bond is a type of debt instrument that pays investors fixed interest payments known as coupons, at regular intervals until maturity. At the end of the bond’s term, the face value is repaid to the investor. Coupon bonds are widely used by corporations and governments to raise capital, offering predictable income to investors through periodic interest payments.

What is Coupon Bond?

The coupon bond meaning refers to a fixed-income security that pays interest to the bondholder at regular intervals typically semi-annually or annually. These interest payments, called “coupons,” are based on a fixed percentage of the bond’s face value. At maturity, the issuer repays the principal amount to the investor. Coupon bonds are commonly issued by governments and corporations to raise long-term capital.

How a Coupon Bond Works?

A coupon bond works by providing investors with fixed interest payments, known as coupons, at regular intervals until maturity. Here’s how it functions:

• The bond is issued with a face value (e.g., ₹1,000) and a coupon rate (e.g., 7% annually).
• The investor receives periodic interest payments (₹70 annually in this example) for the life of the bond.
• At maturity, the issuer repays the full face value to the investor.
• Coupon payments are usually made semi-annually or annually.
• These bonds can be traded in the secondary market and their price may vary based on interest rates and credit risk.

Functions of Coupon Bond

Coupon bonds serve multiple purposes for both issuers and investors. Here are the key functions:

1. Provides Fixed Income: Offers regular interest payments (coupons) to investors.
2. Capital Raising Tool: Helps companies and governments raise long-term capital.
3. Market Liquidity: Tradable in secondary markets, offering liquidity to investors.
4. Predictable Returns: Fixed coupon rate ensures predictable income over time.
5. Risk Management: Used by investors to diversify portfolios and manage interest rate risk.
6. Credit Indicator: The yield and price reflect the issuer’s creditworthiness and market conditions.

Components of a Coupon Bond

Before investing in a bond, an investor must correctly understand the main components of a coupon that are mentioned below:

1. Face Value: This is the amount that the bondholder will receive at maturity. Also called the par value, this will remain constant throughout the bond’s lifespan.
2. Coupon Rate: The fixed interest rate applied to the bond’s face value to determine periodic payments. It remains unchanged unless it’s a floating-rate bond.
3. Maturity Date: The date when the bondholder will be repaid the principal amount.
4. Issuer: The entity that issues the bond, which could be a private company, public company, municipality, PSU or a government body.
5. Yield: Bond prices fluctuate daily due to market conditions that influence the bond prices. Hence, yield is used to calculate the actual return made by an investor from holding the bond.

Types of Coupon Bonds

Coupon bonds come in various forms based on how interest is paid and structured. Here are the main types:

• Fixed-Rate Coupon Bonds: Offer a fixed interest rate throughout the bond’s life.
• Floating-Rate Coupon Bonds: Interest rate varies based on market benchmarks like LIBOR or MCLR.
• Zero-Coupon Bonds: Issued at a discount and do not pay periodic interest; full face value is paid at maturity.
• High-Yield Bonds (Junk Bonds): Offer higher interest rates due to lower credit ratings and higher risk.
• Convertible Bonds: Can be converted into a set number of equity shares of the issuing company.
• Perpetual Bonds: Have no maturity date and pay interest indefinitely.

Coupon Bond Pricing and Formula

The price of a coupon bond depends on the market interest rate, bond tenure and face value. The formula used to calculate the price of a coupon bond is:

Bond Price = ∑ [C / (1 + r)^t] + (F / (1 + r)^n)

Where:

• C= Coupon payment
• r= Market interest rate
• t= Period of coupon payments
• F= Face value of the bond
• n= Number of years to maturity

Example of a Coupon Bond

Let’s look at an example to comprehend the coupon bond better.

X Company issued a bond on August 28, 2024. The bond comes with a coupon rate of 10.5%, meaning investors receive interest on their investment. This bond has a face value of Rs 1,00,000 and matures in August 2027.

Unlike zero coupon bonds, which do not pay any periodic interest, this bond provides monthly interest payments to investors. It offers returns with a yield-to-maturity (YTM) of 10.90%. It is rated A by CRISIL, indicating minimal credit risk. However, bond investors should assess the issuer’s financial health before investing.

For instance, an investor buys this bond worth Rs 1,00,000. With a coupon rate of 10.5% per annum, the investor will receive Rs 875 per month (₹1,00,000 × 10.5% ÷ 12) as interest. In August 2027, upon maturity, the investor will receive the principal amount of Rs 1,00,000.

An investor may choose to sell the bond in the secondary market before maturity. However, the bond’s price will depend on prevailing interest rates. If interest rates rise, newly issued bonds may offer higher returns, making existing bonds less attractive, which lowers their price. And suppose if the interest rates fall, existing bonds with higher coupon rates become more valuable, leading to the price increase of bonds.

Benefits of coupon bonds

Coupon bonds offer several advantages for investors seeking steady income and capital preservation:

• Regular Income: Provide periodic interest payments (usually semi-annually), offering predictable cash flow.
• Capital Preservation: Safer than equities; ideal for conservative investors looking to preserve capital.
• Diversification: Adds stability to a portfolio by balancing riskier investments.
• Fixed Returns: Fixed-rate bonds offer returns that aren’t affected by market volatility.
• Tradability: Can be bought or sold in the secondary market, offering liquidity.
• Tax Benefits: Certain government-issued bonds may offer tax exemptions on interest earned.

Limitations of Coupon Bonds

Despite offering stable income, coupon bonds come with certain drawbacks:

• Interest Rate Risk: Bond prices fall when interest rates rise, potentially leading to capital loss.
• Inflation Risk: Fixed interest payments may lose value over time due to inflation.
• Credit Risk: If the issuer defaults, investors may lose interest payments or principal.
• Lower Returns: Compared to equities, returns may be modest, especially in low-rate environments.
• Liquidity Risk: Some bonds may not be easily tradable in the secondary market.
• Reinvestment Risk: Interest payments may need to be reinvested at lower rates if interest rates decline.

Who Should Invest in Coupon Bonds?

Coupon bonds are ideal for investors seeking regular income with relatively lower risk. They are best suited for:

• Retirees looking for steady interest income.
• Conservative investors prioritising capital preservation.
• Income-focused investors who want predictable returns.
• Long-term investors seeking portfolio stability.
• Diversified portfolios aiming to balance equity volatility.

These bonds suit anyone wanting consistent returns without high exposure to market swings.

Role of Coupon Bonds in a Diversified Portfolio

Coupon bonds play a crucial role in balancing risk and return within a diversified investment portfolio. They offer:

• Stable Income: Provide predictable interest payments, ensuring a steady cash flow.
• Risk Mitigation: Help reduce overall portfolio volatility by offsetting equity market fluctuations.
• Capital Preservation: High-rated bonds offer safety of principal, especially during market downturns.
• Diversification: Their performance often differs from stocks, reducing correlation and enhancing portfolio resilience.
• Inflation Hedging: Certain types like inflation-indexed bonds can protect purchasing power.
• Asset Allocation Balance: Useful in maintaining a conservative or income-focused investment strategy.

Conclusion

Coupon bonds are the most standard type of bonds. They provide the best investment strategy for people who want reliable returns and financial security over a long term. To arrive at informed investment decisions, one needs to know the components of a coupon bond, its working mechanism, the pricing model and relevant risk factors. If your motive is to achieve capital protection and periodic income, then it is advised you include coupon bonds in your investment portfolio.