What it is:
How it works/Example:
Actual coupon bonds are rare today because most bonds are not issued in certificate form; rather, they are registered electronically (although some bondholders still choose to hold paper certificates). Thus, these days the term coupon refers to the rate of interest on a bond rather than the physical nature of the certificate.
In the 1980s, some financial institutions began purchasing coupon bonds and selling the coupons as separate securities, called strips.
Let's assume you purchase a $1,000 XYZ Company coupon 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 certificate and present it to an agent of the issuer.
Why it matters:
The fact that coupon bonds are usually bearer bonds is important, because it means that anyone who presents the coupon to the issuer is entitled to the interest payment regardless of whether that person is the owner of the bond. For obvious reasons, coupon bonds present a wide range of fraud and tax evasion opportunities, so 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.