Coupon bond

Definition

A coupon bond is a type of debt security that pays periodic interest payments, known as coupons, to the bondholder until maturity, at which point the face value of the bond is repaid. This structure allows investors to receive regular income from their investment, making coupon bonds attractive for those seeking steady cash flow. The pricing of these bonds is influenced by interest rates, market demand, and the creditworthiness of the issuer, while their duration and convexity help assess interest rate risk and price sensitivity.

5 Must Know Facts For Your Next Test

1. Coupon bonds typically have fixed interest payments that are paid semi-annually or annually until maturity.
2. The price of a coupon bond inversely correlates with interest rates; when rates rise, the price of existing bonds falls and vice versa.
3. Investors use the coupon rate to gauge the bond's attractiveness compared to current market yields.
4. The duration of a coupon bond measures its sensitivity to changes in interest rates, indicating how much the price will change with a shift in rates.
5. Convexity is an important concept for coupon bonds as it accounts for the curvature in the relationship between bond prices and interest rates, providing a more accurate measure of price sensitivity.

Review Questions

• How does the coupon structure of a bond influence its pricing in relation to current market interest rates?
  • The coupon structure determines the periodic interest payments that a bondholder receives. When current market interest rates rise above the coupon rate, existing bonds with lower rates become less attractive, leading to a decrease in their market price. Conversely, if market rates fall below the coupon rate, existing bonds become more desirable, driving their prices up. This relationship highlights how essential understanding interest rates is when evaluating bond pricing.
• Discuss the significance of duration and convexity in managing the risks associated with investing in coupon bonds.
  • Duration helps investors assess how sensitive a coupon bond's price is to changes in interest rates. A longer duration means higher sensitivity and risk. Convexity adds another layer by accounting for how this sensitivity changes with varying interest rate movements. Together, these metrics enable investors to better manage interest rate risk by understanding potential price fluctuations based on market conditions.
• Evaluate how variations in coupon bonds' features can impact investor behavior and market dynamics.
  • Variations in features such as coupon payment frequency, maturity length, and credit quality significantly influence investor behavior. For example, bonds with higher coupon rates may attract more conservative investors seeking reliable income streams. Meanwhile, bonds with longer maturities or lower credit ratings may appeal to risk-tolerant investors seeking higher returns. These preferences shape market dynamics by affecting demand and pricing across different types of coupon bonds, ultimately influencing overall market conditions.

Related terms

Face Value: The amount the bondholder will receive at maturity, also known as par value.

Yield to Maturity (YTM): The total return anticipated on a bond if held until it matures, expressed as an annual rate.

Interest Rate Risk: The potential for investment losses due to fluctuations in interest rates, which can affect bond prices.