What it is:
How it works/Example:
Actual bearer bonds are uncommon today because nearly all bonds are registered electronically rather than in certificate form. (although some bondholders still choose to receive paper certificates). Therefore, the term coupon refers to the interest rate of a bond rather than the physical nature of the certificate.
In the 1980s, some financial institutions started buying bearer bonds and selling the coupons as separate securities, called strips.
Let's assume you purchase a $1,000 XYZ Company bearer bond. The coupon rate on the bond is 5%, which means the issuer will pay you 5% interest per year, or $50, on the face value of the bond ($1,000 x 0.05). Even if your bond trades for less than $1,000 (or more than $1,000), the issuer is still responsible for paying you $50 per year. To claim your interest payment, you would simply clip off the appropriate coupon from the bond's certificate and show it to an agent of the issuer.
Why it matters:
Coupon bonds are called bearer bonds for a reason. That is, anyone who presents the coupon to the issuer is entitled to the interest payment even if that person is not the owner of the bond. Therefore, since bearer bonds offer many fraud and tax evasion opportunities, they are nearly unheard of today.
Instead, modern bonds are usually registered bonds or book entry bonds. Registered bonds are bonds with physical certificates that describe the terms of the debt, and the registered holder receives interest payments automatically from the issuer. Book entry bonds are bonds that are electronically registered to the financial institution acting on behalf of the investor. The investor receives a receipt for his or her bond in lieu of a certificate, and the investor's account at the financial institution receives the interest payment.