A coupon payment is the interest a bond issuer pays to its bondholders on a set schedule until the bond matures. The amount is fixed by two numbers written into the bond when it is issued: the face value (usually $1,000 for a corporate bond) and the coupon rate (a stated annual percentage). Multiply one by the other and you get the annual interest. A $1,000 bond with a 4% coupon rate pays $40 a year, almost always split into two $20 payments six months apart.1SEC.gov. What Are Corporate Bonds?
How the Dollar Amount Is Set
The coupon rate and the par value are both locked in on the day the bond is issued and written into the bond indenture, the legal contract between the issuer and its bondholders. The math never changes: coupon rate times par value equals annual interest. A 5% coupon on a $1,000 bond produces $50 a year for the life of that bond. A 4% coupon produces $40. Nothing that happens later in the market changes what the issuer owes you each year.
How Often Coupons Are Paid
Although the coupon rate is quoted annually, most corporate and government bonds pay semiannually.1SEC.gov. What Are Corporate Bonds? A $1,000 bond with a 5% coupon sends $25 every six months, not $50 once a year. Some bonds pay quarterly or monthly, but the semiannual schedule is the default you should assume unless the offering documents say otherwise.
Each payment cycle has a record date and a payable date. Whoever owns the bond on the record date receives the coupon; the cash lands in that holder’s account a short time later on the payable date. If a bond changes hands close to a payment date, the accrued-interest rules described below govern how the payment gets split between buyer and seller.
Fixed, Floating, and Inflation-Adjusted Coupons
Fixed-Rate Coupons
Most bonds carry a fixed coupon rate, so the dollar amount of every payment is identical from the first coupon through maturity. A 10-year bond with a 4% coupon on $1,000 par pays $40 a year for all 10 years no matter what interest rates do in the broader economy. That predictability is the main appeal for income-focused investors.
Floating-Rate Coupons
Floating-rate bonds tie their coupon to a benchmark interest rate, so the payment resets on a schedule. For U.S. dollar debt, the leading benchmark is the Secured Overnight Financing Rate, or SOFR, which replaced LIBOR as the preferred reference rate.2Federal Reserve Bank of New York. About Transition From LIBOR A floater might be described as SOFR plus a fixed spread, for example SOFR plus 28 basis points (0.28%).3World Bank. World Bank’s SOFR Index-Linked Floating Rate Bond Draws Diverse Investor Demand When the benchmark moves, the next coupon is recalculated at the new rate.
Inflation-Adjusted Coupons (TIPS)
Treasury Inflation-Protected Securities have a fixed coupon rate, but that rate is applied to a principal amount that adjusts with inflation based on the Consumer Price Index.4TreasuryDirect. Treasury Inflation-Protected Securities (TIPS) When the CPI rises, the adjusted principal rises with it, and your dollar payment goes up even though the coupon rate is unchanged. TIPS pay every six months, and the Treasury publishes daily index ratios you can use to work out the inflation-adjusted amount for any period.5TreasuryDirect. TIPS/CPI Data
Why Bond Prices Move But the Coupon Doesn’t
The coupon rate is fixed at issuance, but the bond’s price in the secondary market moves up and down, and price and yield always move in opposite directions. When the price rises above par, the yield falls below the coupon rate; when the price falls below par, the yield rises above it.6FINRA. Understanding Bond Yield and Return
Take three bonds, each with a $1,000 face value and a 4% coupon rate. Trading at par ($1,000), the yield is exactly 4%. Trading at a discount ($900), the yield is higher than 4% because you paid less for the same $40 annual payment. Trading at a premium ($1,100), the yield is lower than 4% because you paid more.1SEC.gov. What Are Corporate Bonds? In all three cases the coupon payment itself is still $40 a year. The issuer’s obligation does not shift with the market price.
Hold the bond to maturity and you collect every scheduled coupon plus the face value at the end, subject to the risk that the issuer defaults. Secondary-market price swings only affect your return if you sell early.1SEC.gov. What Are Corporate Bonds?
Accrued Interest When You Buy or Sell Between Coupons
Bonds trade every day, not only on coupon dates, so the interest that has built up since the last payment has to be settled between the parties. When a bond trades between coupon dates, the buyer pays the seller accrued interest: the portion of the upcoming coupon that the seller earned by holding the bond so far. When the next full coupon arrives, it goes to the buyer, who effectively gets back the accrued interest paid at purchase.7FINRA. Bonds
Say a $1,000 bond paying 5% semiannually trades exactly three months after the last coupon date. The seller has earned about half of the $25 semiannual payment, roughly $12.50. The buyer pays the market price plus that $12.50. Three months later, the full $25 coupon shows up in the buyer’s account, netting them about $12.50 for the three months they actually owned the bond.
Bond prices are usually quoted as a “clean price” that excludes accrued interest, while the total you actually pay (the “dirty price” or “full price”) includes it. For tax purposes, the buyer can subtract the accrued interest paid to the seller from the first full coupon received, so you only owe tax on the interest you truly earned.
When Coupon Payments Can Stop Early
Callable Bonds
Many corporate and municipal bonds are callable, which means the issuer has the right to redeem them before maturity.8Investor.gov. Callable or Redeemable Bonds If your bond is called, the issuer pays you the call price (typically face value, sometimes slightly above) plus any accrued interest, and coupon payments stop from that point on.9FINRA. Callable Bonds: Be Aware That Your Issuer May Come Calling
Issuers usually call bonds when rates have fallen, so they can refinance at a lower coupon.8Investor.gov. Callable or Redeemable Bonds Good for the issuer, harder on you: if you expected 10 years of 5% coupons and the bond is called after five, you lose the rest of the income stream and are likely reinvesting in a lower-rate market.9FINRA. Callable Bonds: Be Aware That Your Issuer May Come Calling Callable bonds often carry a slightly higher coupon than comparable noncallable bonds, and some include a call premium above face value paid on early redemption. Before you buy, check whether the bond is callable, when it can first be called, and at what price.
Missed Payments and Default
If an issuer misses a scheduled coupon, the indenture usually gives it a grace period, often around 30 days, before an event of default is formally declared. Once that period runs out, bondholders and the trustee can act to enforce the indenture. If the issuer files for bankruptcy, bondholders become creditors, and where they stand in line depends on whether they hold secured, senior unsecured, or subordinated debt, along with the claims of banks, suppliers, employees, and pension funds.1SEC.gov. What Are Corporate Bonds?
How Coupon Income Is Taxed
The IRS treats bond interest as ordinary income, so coupon payments are taxed at your regular income tax rate rather than the lower capital gains rate.10Office of the Law Revision Counsel. 26 U.S. Code 61 – Gross Income Defined Your broker or the issuer’s paying agent sends you a Form 1099-INT each year showing the total interest paid, and you report that amount on your federal return.11Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID Corporate bond interest is also subject to state income tax in most states that impose one.
Interest from state and local government bonds is generally excluded from federal income tax.12Office of the Law Revision Counsel. 26 U.S. Code 103 – Interest on State and Local Bonds Most states also exempt interest on bonds issued within the investor’s home state, while bonds from other states are usually taxable at the state level. That tax advantage lets municipalities borrow at lower rates.
One exception matters if you may owe alternative minimum tax: interest on certain private activity bonds counts as a tax preference item under the AMT.13Office of the Law Revision Counsel. 26 U.S. Code 57 – Items of Tax Preference Bonds issued for section 501(c)(3) nonprofits, certain housing bonds, and qualified veterans’ mortgage bonds are excluded from that treatment. If AMT applies to you, verify whether your municipal bonds fall into the private activity category before assuming all the interest is tax-free.
Bonds That Pay No Coupons
Not every bond has coupon payments. Zero-coupon bonds pay no periodic interest at all. They are sold at a deep discount to face value, and your return is the gap between what you paid and the par value you receive at maturity.14Investor.gov. Zero Coupon Bond
Even though no cash arrives until maturity, the IRS generally still expects federal, state, and local income tax each year on the imputed interest that accrues.14Investor.gov. Zero Coupon Bond Federal law requires holders of debt issued at an original issue discount to include a portion of that discount in gross income each year, calculated using a constant-yield method.15Office of the Law Revision Counsel. 26 U.S. Code 1272 – Current Inclusion in Income of Original Issue Discount You owe tax on income you have not yet received, which is why zero-coupon bonds are often held inside IRAs or other tax-advantaged accounts.