Different types of bonds pay interest in different ways, and at different times.
Fixed Rate Coupon Bonds
Most fixed rate bonds pay the coupon interest payment on a semi annual basis, so you receive an interest payment every 6 months. The difference between bonds which pay a coupon, and zero coupon bonds, is that since you are getting paid out the interest every 6 months, so compounding does not happen automatically. This is an important difference to understand for two reasons:
- In order to take advantage of the power of compounding with bonds that pay a coupon, you have to re invest the interest payments as you receive them.
- The rate at which your money will compound is directly tied to the interest rate you receive when re-investing the coupon payments. As interest rates change over time, this is a huge factor in the overall return a bond investor earns over time as well.
You can learn more about zero coupon bonds here.
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Example 1: 10 Year $10,000 Fixed Rate Bond Paying a Coupon of 10%. No Reinvestment.
If you buy and hold this bond for the full 10 years, you will receive a $500 coupon interest payment every six months, for a total of $1000 Per year. If you do not reinvest the coupon payments, then at the end of 10 years you will have earned $10,000 in interest on your original $10,000 investment.
Example 2: Same Exact Bond. Reinvestment Rate 10%.
If you buy and hold the same bond for the full 10 years, and invest the coupon payments at the same rate of 10% then at the end of 10 years you will have earned 16,532.98 on your original $10,000. In this example you earned an additional 65% worth of total interest ($6,532.98), simply for reinvesting your coupon payments than you would have otherwise.
Example 3: Same Exact Bond. Re Investment Rate 5%.
If you buy and hold the same bond for the full 10 years, and invest the coupon payments at 5%, then at the end of 10 years you will have earned $12,722.33 on your original $10,000. When comparing this to the $16,532.98 you earned on the same $10,000, when reinvested at 10% you can see the large difference that the reinvestment rate makes.
Zero Coupon Bonds and Compounding
Zero coupon bonds are the easiest bonds to evaluate when it comes to compound interest, because the interest payment comes all at once, at the end of the term of the bond. Although you only receive your interest payment at the end of the bond’s term (at maturity) this does not mean that you do not get to take advantage of compounding. The lump sum you receive at maturity includes the effects of compounding, as if you were receiving interest payments semi-annually and re-investing them at the bond’s interest rate.