Understanding the Bond Coupon
By Acceler8now.com Bond Investing Team August, 2007
A bond is issued with a coupon, also called coupon rate. The coupon of a bond is the interest rate stated on it, which determines the amount of interest the buyer receives at the stated intervals. Put differently, the coupon is the interest the bondholder receives, expressed as a percentage and stated on the bond.
At some point in the past, such coupons were actually attached physically to bonds, to be detached for redemption at interest due-dates. The key point, though, is that you need to know the coupon rate, among other factors, when you consider investing in a bond, since that defines the interest you will be receiving.
Basic Fixed-rate Bond
Generally, bonds are classified as fixed-income securities. This derives largely from the fact that the coupon is fixed, just as the par value (the face value of the bond), making possible a fixed income stream. It is therefore possible to know what interest you will receive at the payment intervals, usually every six months, on the bond.
The fixed-rate type is the more dominant class of bonds. Market changes, especially as to interest rates trends, can pose a challenge to fixed rates. One problem here is that when interest rates are generally up, holders of such fixed rate bonds are at a disadvantage and vice versa. One way to mitigate that development is by allowing the rate to float.
Floating Rate Bonds
A bond can be structured to have a coupon that adjusts with interest rate trends by floating with the market. So, instead of a fixed rate that applies all through the term of the bond, its rate is tied to an index or benchmark. A benchmark could be the T-bills rate, with the coupon being set as 'x-points below/above' that rate or at par with it. What this means is that the coupon rate is reset at intervals. Floating rates help adjust for interest rate movements and consequently help stabilise the price of the bonds.
Zero-Coupon Bonds
The name says it: there is no coupon and so, no interest is paid. However, that does not mean that the buyers give out their money for free, since no investor will get into such arrangement. Zero-coupon bonds are bought at a discount, a level of discount that justifies the investment, much as when Treasury bills are bought or if you have ever invested in a BA (bankers' acceptance). This means that the buyer takes his income upfront: a 10% discount for a bond of N1,000 par value means the buyer pays N900 to buy. At maturity, the face value (N1,000) is paid, the income being the discount received at time of purchase.
Inflation Adjusted Bonds
The inflation linked bonds are structured to help investors cushon the impact of inflation on the investment. The coupon is unaltered, but the principal sum is what is indexed to inflation, meaning that the principal sum can grow if inflation works to diminish the real value of the initial principal sum. That way, the interest sum also increases, helping investors earn income that is aims to match up with inflation. The US TreasuryInnflation-Protected Securities (TIPS) fall into this category.
What to Go For
Ordinarily, the next logical question will be to ask which coupon type to go for. That question would however have limited application in the Nigerian situation where the bond market is obviously shallow at the moment, leaving no serious room for choice. Currently, only Federal Government of Nigeria bonds are traded. Those bonds are either of fixed rate or floating coupon. So, it's one or the other. Given the government's avowed drive to push interest rates down, and expecting that some measure of success will result, it may make sense to lock into fixed current rates. That's, however, if you think rates will go down. If rates do go down and you hold an instrument whose rate floats, it simply means your income is going to float downwards since that rate will end up adjusted downwards. The choice will therefore depend on your expectation about the direction of interest rates.
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