Bonds are debt instruments sold by corporations and government agencies to raise money. Bond issuers calculate interest payments in accordance with the terms of the bond agreement. They calculate and pay interest on most types of bonds in similar ways, but there are a few important exceptions.
Basics of Bond Interest Payments
The interest rate a bond pays is fixed, meaning it is good until it matures. Bonds have a par or face value, which is the sum the issuer repays at maturity. The interest rate, called a coupon rate, is a percentage of the par value. Interest usually is paid at six month intervals, which makes calculating payments simple. Divide the coupon rate in half and multiply by the par value.
Suppose the coupon rate for a $1,000 bond is 6 percent. Divide 6 percent in half and multiply by $1,000. The interest payment is $30 every six months.
Corporate bonds usually pay higher interest rates than government bonds because they carry more risk. State and local bonds, collectively called municipal bonds, often pay lower interest rates because they usually are tax exempt and considered to be safer investments.
Corporations, financial institutions and foreign governments frequently borrow money via short-term bonds called commercial paper. These bonds generally mature in 270 days or less. Rather than try to schedule interest payments, issuers sell the bonds at a discount off the par value. For example, a bank might sell a commercial paper bond with a 180 day maturity and $100,000 par value for $98,000. The investor receives $100,000 at maturity, thus earning $2,000 interest. The interest percentage equals $2,000 divided by $98,000, or 2.04 percent. Multiply the percentage by two to convert to the annual rate of 4.08 percent.
Like commercial paper, zero-coupon bonds sell at a discount off par value. However, state and local governments typically issue these bonds with maturities of several years. The U.S. Treasury and some corporations also sell zero-coupon bonds. Interest isn’t paid out at regular intervals. The money earned accrues and increases the bond’s value, so the bond earns more interest as time passes. The discount price is selected so that the original price of the bond plus accrued interest exactly equals the par value at maturity. At this point, the bond issuer retires the bond by paying the investor the original purchase price plus accrued interest in a single payment.
United States Savings Bonds
Individuals and organizations purchase Series EE and Series I United States Savings Bonds through TreasuryDirect.gov. Savings bonds work like zero-coupon bonds in that you do not receive periodic interest payments. Interest is added periodically and you get your original investment plus accrued interest when you redeem the bond. However, you do not have to wait until the bond matures to cash it in. You may redeem a savings bond anytime starting one year after you buy it.
Series I bonds have an additional feature: a hybrid interest rate. One part is fixed. The other component is adjusted at six-month intervals to offset inflation. Each time interest is calculated, the fixed rate and inflation rate percentages are multiplied by the current value of the Series I bond. The interest earned is added to the bond, increasing its value.