Coupon bond

Definition

A coupon bond is a debt security that pays periodic interest payments, known as coupons, to the bondholder until its maturity date, at which point the face value is repaid. This type of bond allows investors to receive regular income while lending money to the issuer, whether it be a corporation or government entity. The fixed interest payments make coupon bonds attractive for investors seeking predictable returns.

5 Must Know Facts For Your Next Test

1. Coupon bonds typically have fixed interest rates, meaning the coupon payments remain constant throughout the life of the bond.
2. The coupons are often paid semi-annually or annually, providing a steady stream of income for bondholders.
3. If interest rates rise after a coupon bond is issued, its market value may decrease because new bonds would be issued with higher rates, making older bonds less attractive.
4. Coupon bonds can be traded in secondary markets, allowing investors to buy or sell them before maturity at market prices.
5. The duration of a coupon bond helps measure its sensitivity to interest rate changes, with longer-duration bonds generally experiencing greater price volatility.

Review Questions

• How do coupon payments affect an investor's decision when purchasing a coupon bond?
  • Coupon payments provide investors with regular income, which is an essential factor in their decision-making process. When evaluating a coupon bond, investors will consider not only the coupon rate but also how it compares to prevailing market interest rates. If the coupon rate is attractive relative to alternatives, it may influence their choice to invest in that particular bond over others.
• Discuss how fluctuations in interest rates impact the market value of coupon bonds.
  • Fluctuations in interest rates have a direct impact on the market value of coupon bonds. When interest rates rise, newly issued bonds often offer higher coupons, making existing bonds with lower rates less appealing. Consequently, this can lead to a decline in the market price of older coupon bonds as investors seek better yields elsewhere. Conversely, if interest rates fall, existing coupon bonds may see an increase in their market value since their fixed payments become more attractive.
• Evaluate the role of duration and convexity in managing investment risk associated with coupon bonds.
  • Duration and convexity are crucial metrics for managing investment risk in coupon bonds. Duration measures the sensitivity of a bond's price to changes in interest rates, indicating how much its price may fluctuate with rate movements. Convexity complements duration by assessing how the price-yield relationship changes as interest rates change; higher convexity suggests less risk for price declines when rates rise. Investors use these measures to optimize their portfolios by balancing yield and risk exposure while ensuring they understand how price movements could affect their investments over time.

Related terms

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

Face Value: The nominal value of a bond that is paid back to the bondholder at maturity; it is also the amount upon which interest payments are calculated.

Maturity Date: The date on which the principal amount of a bond is due to be paid back to the bondholder, marking the end of the bond's life.