When an investor or trader purchases shares of stock in a company, they are purchasing the rights to a portion of that company’s profits. Dividend payment is based on profit, and if profits slump, so too will dividends. This means that dividends fluctuate and, in some cases, may not be paid at all.
Coupon payments, on the other hand, are regular payments of fixed interest on a bond. Bonds are essentially loans from the bondholder to the bond issuer. These IOUs promise interest payments (coupon payments) and are obligated by contract.
In the case of bonds, these interest rates are set when the bonds are issued. They do not change even if the bond changes hands in the aftermarket. This is particularly important for retirees who rely on bond coupon payments as a regular fixed income supplement.
When a bond is issued, it is assigned an expiration date known as a maturity date. When the bond reaches maturity, the principal is repaid. The length of time that a bond takes to reach maturity is known as the “term” of the bond.
These terms can range from as little as a year or two all the way up to 30 years. Generally, the longer the term, the higher the coupon payments. Additionally, bonds are rated based on the reliability of the issuer and their chances of defaulting. The higher the risk, the higher the interest rate.
The Relationship Between Coupon Payments and Bond Price
When evaluating the price of a bond, there are several factors to consider.
The face value of the bond, or the principal is an important factor, along with the bond’s maturity date. Basically, these two pieces of information tell investors how much money they will be committing and for how long it will be on loan to the bond issuer.
Also important is the creditworthiness of the bond issuer. Treasury bonds are backed by the full faith and credit of the United States. A more ringing endorsement is hard to come by. This creditworthiness also translates into lower coupon payments, however.
The payments over the term of a bond are expressed in what’s called a coupon rate. A bond’s coupon rate is calculated by taking the yearly sum of coupons paid—they are usually paid semiannually—then dividing that number by the principal (the face value).
If a bond with a face value of $2,000 earns a bondholder $100 per year in two payments of $50 each, that bond has a coupon rate of 5 percent, or ($50x2)/$2,000.
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