A Coupon is the payment that the bond issuer pays the bond holder at certain frequency. Normally the coupon is paid semi-annually or annually. Some of the most common types of Bonds based on their coupon rate structures are:
1) Fixed Rate Bonds have a constant coupon rate throughout the life of the bond. For example: a Treasury bond with face amount (or principal amount) $1000 that has a 4% coupon and matures 6 years from now, the U.S. Treasury has to pay 4% of the par value ($40) each year for 6 years and the par value ($1000) at the end of 6 years. If the annual interest is paid in two semiannual installments, the Treasury will pay the bond holder $20 every six months for the 6 years (in total 12 installments) and finally the principal (the original $1,000) at the end of the 6 years. In either way, the stream of payments is the same over the life of the bond. Most government bonds are in this category.
2) Zero-Coupon Bonds do not have periodic interest. The issuer simply pays the par value at the maturity. The zero-coupon bonds are sold at a substantial discount to par value.
3) Floating Rate Bonds have coupon rates that vary based on market interest rate or specific index (we call it reference rate) over the life of the bonds. The common formula to calculate the coupon rate is: new coupon rate = reference rate ± quoted margin.
Some examples of the reference rate are: the London Interbank Offered Rate (LIBOR), Euro Interbank Offered Rate (Euribor) , rate on certain U.S. Treasury Securities, change in CPI, etc. The issuer or the bond holder can limit the risk to extreme fluctuations in the reference rate by placing upper limit (cap) and/or lower limit (floor) on the coupon rate.
