You may remember clipping bond coupons and mailing them in to receive an interest payment. Electronic bookkeeping replaced coupon clipping two decades ago, but the term coupon is still an important part of the bond investor's vocabulary. A bond's coupon is the annual interest rate paid on the issuer's borrowed money, generally paid out semiannually. The coupon is always tied to a bond's face or par value, and is quoted as a percentage of par. For instance, a bond with a par value of $1,000 and an annual interest rate of 4.5% has a coupon rate of 4.5% ($45).
Coupon Choices
Say you invest $5,000 in a six-year bond paying 5% per year, semiannually. Assuming you hold the bond to maturity, you will receive 12 interest payments of $125 each, or a total of $1,500. This coupon payment is simple interest.
You can do two things with that simple interest—spend it or reinvest it. Many bond investors rely on a bond's coupon payments as a source of income, spending the simple interest they receive.
When you reinvest a coupon, however, you allow the interest to earn interest. The precise term is "interest-on-interest," though we know it by another word: compounding. Assuming you reinvest the interest at the same 5% rate and add this to the $1,500 you made, you would earn a cumulative total of $1,724, or an extra $224. Of course, if the interest rate at which you reinvest your coupons is higher or lower, your total return will be more or less. Also be aware that taxes can reduce your total return. To learn more about the impact of taxes, read our Bonds and Taxes section.
The Power of Compounding
Regardless of the type of investment you select, saving regularly and reinvesting your interest income can turn even modest amounts of money into sizable investments through the remarkable power of compounding. If you save $200 a month and receive a 5% annual rate of return, you will have more than $82,000 in 20 years' time.
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