In the world of personal finance, “coupon” and “discount” actually have two different meanings. One applies at the store, the other applies when you’re buying bonds. In the interest of teaching you about complete personal finance, I’m going to cover both definitions.
Let’s start with the grocery store, or any other retail outlet. A discount is a price reductionon an item or service that you purchase. If a t-shirt normally sells for $10 and you buy it for $8, you got a $2 discount, or a 20 percent discount.
A coupon, within this context, is a piece of paper (or an electronic code) that gives you access to a discount. Coupons used to be pieces of paper that you’d clip out of newspapers and magazines, although these days you can download e-coupons or use coupon apps. When you present a coupon, you get to take advantage of a discount that other shoppers, who don’t have coupons, cannot take advantage of.
Okay, that’s simple enough, right?
Now let’s talk about coupons and discounts in the world of bond investing.
“Why do I need to know about bonds? I’m an ordinary American. I don’t work on Wall Street!”
Because the vast majority of Americans don’t have access to a retirement pension plan. If you’re in the majority, you’re directing the investing choices within your 401k account, IRA account or other retirement accounts.
“Okay, then. What does ‘coupon’ and ‘discount’ mean, as it applies to bonds?”
Glad you asked. A “coupon” is a periodic interest payment on a bond that you (the bondholder) earns during the time that you hold the bond.
Okay, let me back up a little bit ...
When you buy a bond, you’re buying someone elses’ debt. That “someone else” might be a corporation, a city government, or the U.S. Treasury.
As a “bondholder,” you carry the note on that debt. In essence, you’re a lender.
Now, because you’re a lender, you deserve to earn period interest payments. After all, when you borrow money from the bank, you have to pay the bank interest periodically. Similarly, when someone else borrows money from you (in the form of a bond), they have to pay interest to you.
So a “coupon” is the interest that you receive during the time that you hold that bond. It ends when you either sell the bond, or when the bond matures (finishes).
Coupons are paid at a “coupon rate.” If a bond has a coupon rate of 5 percent, then it will pay $5 for every $100, each year. Most bonds issue semi-annual payments (twice a year).
A “zero-coupon” bond does not offer any periodic interest payments. You, the bondholder, won’t receive anything during the time that you carry the bond. So why would you want one?
Because you bought the bond for less than its face value. And when the bond matures, you’ll (presumably) get its face value (assuming the borrower doesn’t default). So you’ll forgo periodic interest payments for the opportunity to make a gain on the spread between the price you paid for the bond and its value at maturity.
This is called the “bond discount.” The “discount,” in this context, is the reduction in price between what the bond sells for today, and what the bond’s value will be at maturity. Zero-coupon bonds are sometimes called “discount bonds” or “deep discount bonds.”