When you begin to invest in bonds for the first time, you may hear your broker or other investors refer to the “coupon”. A $25,000 bond that paid 8% interest might be said to have an 8% “coupon”. For new investors who don’t know the history of the stock market or the bond market, this may be confusing and seem odd.
Where the Term Coupon Originated for Bonds
Back in the days before computers, when an investor bought a bond, he or she was given a physical, engraved certificate. They would then go lock these in a safe deposit box. It was important that they be kept secure because it was the proof that they had lent money to the bond issuer and it was what entitled them to receive their money back, plus interest. Each of these bond certificates included an attached section of “coupons” with dates printed on them.
Twice a year, when the interest was due on their bond, the investor would go down to the bank, open the safe deposit box, and physically clip the proper coupon with the current date. They would take the coupon and deposit it, just like cash, into their bank account or mail it in to the company to get a check, depending upon the terms and the circumstances.
An Example of How the Bond Coupon Would Work
If an investor wanted to buy a $25,000 Coca-Cola bond with a 30 year maturity and an 10% coupon, it would work like this: He would send in the $25,000 from his savings account and get a $25,000 engraved bond certificate in exchange. After 30 years, he would be able to get his whole $25,000 back from the Coca-Cola company (of course, he can always sell it before then if he needs the money).
Every year, he’s entitled to receive 10% interest on the money he lent, or $2,500. Since most companies in the United States pay interest semi-annually, he would likely have 60 coupons attached to his bond for $1,250 each. Every June 30th and December 31st, the investor would go down, clip the proper coupon, send it in, and get their money.
Today, bonds don’t work like this. In most cases, you will buy them through a brokerage account and the interest payment will just show up as a deposit in your account. In other cases, they are held in “book entry”, which means that the company records your ownership in a computer program and mails the coupon payment to you when it’s due (in some cases, you could provide your bank information and the money will be electronically deposited into your account). Although the practice is now defunct, the terminology stuck and interest payments on bonds will forever be known as coupons.
