What Are Zero Coupon Bonds?

A zero-coupon bond, also known as an accrual bond, is a debt security that does not pay interest and instead trades at a steep discount, yielding a profit when redeemed for its full face value at maturity.

What is an example of a zero-coupon bond?

A zero coupon bond (sometimes known as a discount bond or a deep discount bond) is a bond that pays the whole face value at maturity. That definition assumes that money has a positive time value. The term “zero coupon bond” refers to a bond that does not pay periodic interest or have “coupons.” The investor receives the par (or face) value of the bond when it matures. US Treasury bills, US savings bonds, long-term zero-coupon bonds, and any other coupon bond that has had its coupons removed are examples of zero-coupon bonds. The terms zero coupon and deep discount bonds are interchangeable.

An investor who owns a normal bond, on the other hand, earns income through coupon payments that are made semi-annually or annually. When the bond matures, the investor also receives the principle, or face value, of the investment.

Some zero coupon bonds are inflation-indexed, meaning that the amount of money paid to the bond holder is estimated to have a certain amount of purchasing power rather than a fixed amount of money, but most zero coupon bonds pay a fixed amount known as the face value of the bond.

Zero coupon bonds can be held for a long or short period of time.

Maturity dates for long-term zero coupon bonds typically range from ten to fifteen years. Bonds can be kept until they mature or traded on secondary bond markets. Short-term zero coupon bonds, sometimes known as bills, have maturities of less than one year. The world’s most active and liquid debt market is the US Treasury bill market.

What exactly are the advantages of zero-coupon bonds?

A zero-coupon bond is a low-cost investment that can be used to save for a specific objective in the future. A zero-coupon bond does not pay interest on a regular basis, but instead sells at a substantial discount and pays the full face value at maturity. Zero-coupon bonds are appropriate for long-term, specific financial needs that can be met in the near future.

Example 1: Annual Compounding

John is interested in purchasing a $1,000 zero-coupon bond with a 5-year maturity date. The bond’s yearly interest rate is 5% compounded annually. What will John pay today for the bond?

Example 2: Semi-annual Compounding

John is interested in purchasing a $1,000 zero-coupon bond with a 5-year maturity date. The bond has a 5-percentage-point interest rate that is compounded semi-annually. What will John pay today for the bond?

Reinvestment Risk and Interest Rate Risk

Reinvestment risk refers to the possibility that an investor may be unable to reinvest the cash flows (coupon payments) from a bond at the needed rate of return. Zero-coupon bonds are the only fixed-income assets that do not entail periodic coupon payments and hence are not subject to investment risk.

The danger that an investor’s bond would lose value owing to interest rate variations is known as interest rate risk. Interest rate risk impacts all sorts of fixed-income assets and is crucial when an investor decides to sell a bond before maturity.

Consider the case of John, who paid $783.53 for a $1,000 zero-coupon bond with a 5-year maturity and a 5% annual interest rate compounded annually. Assume that interest rates increase from 5% to 10% immediately after John purchases the bond. What would the bond’s price be in such a scenario?

If John sold the bond right after buying it, he would lose $162.61 ($783.53 $620.92).

More Resources

Thank you for taking the time to read CFI’s Zero-Coupon Bond guidance. The following extra resources are strongly recommended for continuing to acquire and enhance your knowledge of financial analysis:

Is interest paid on zero-coupon bonds?

Except for zero-coupon bonds, most bonds pay monthly interest or “coupon” payments. Zeros, as they’re known, are bonds that don’t have a coupon or interest payment.

If interest rates rise,

Instead of receiving interest payments, you purchase a zero bond at a discount to its face value and are paid the face amount when it expires. For example, a 20-year zero-coupon bond with a face value of $10,000 might cost $3,500. The bond’s issuer pays you $10,000 after 20 years. As a result, zero-coupon bonds are frequently acquired to cover a future obligation such as college fees or a projected retirement payment.

Zero-coupon bonds are issued by federal agencies, municipalities, financial institutions, and corporations. STRIPS is the name of one of the most common zeros (Separate Trading of Registered Interest and Principal Securities). An eligible Treasury asset can be converted into a STRIP bond by a financial institution, a government securities broker, or a government securities dealer. The bond gets stripped of its interest, as the name implies.

STRIPS have the advantage of not being callable, which means they cannot be redeemed if interest rates decline. If your bond is called, you receive cash, and you need to reinvest it, this feature protects you from having to settle for a lower rate of return (this is known as reinvestment risk).

However, zero-coupon bonds come with a variety of risks. If you sell before maturity, zero-coupon bonds, like practically all bonds, are susceptible to interest-rate risk. If interest rates rise, the secondary market value of your zero-coupon bond will certainly fall. Long-term zeros can be particularly vulnerable to interest rate movements, putting them at danger of what is known as duration risk. In addition, zeros might not keep up with inflation. While Treasury zeros pose little danger of default, default risk should be considered while researching and investing in corporate and municipal zero-coupon bonds.

How much does a zero-coupon bond cost?

The price of a zero coupon bond is calculated using a simplified version of the present value (PV) calculation. price = M / (1 + i)nnnnnnnnnnnnnnnnnnnnnnnnnnnnnnn

Because bonds with a coupon commonly pay interest twice a year, zero coupon bond prices are usually calculated using semi-annual periods (twice a year). As a result, Tom can compare investing in a zero coupon bond to investing in a standard bond by estimating the price of a zero coupon bond this way.

Because the needed interest yield is a yearly value, it must be divided in half to provide a semi-annual yield. In addition, because coupon bonds pay out twice a year, the number of years until maturity must be increased by two.

What is the procedure for purchasing Treasury zeros?

With your zero coupon bond order, contact your bank or broker. The bond selling price remains the same regardless of who places your order, but keep in mind that the bond purchase price will include a commission. To save money on your commission charge, go with a discount broker rather than a full-service broker.

Why are zero-coupon bonds so dangerous?

Because all interest payments on zero coupon bonds are compounded and paid at maturity, they are more sensitive to interest rate changes than bonds that pay interest semiannually. The higher the volatility, the longer the bond’s maturity.

What is the purpose of coupon bonds?

A coupon bond is a particular kind of bond. The bond issuer borrows money from bondholders and pays fixed payments to them for a certain period of time at a fixed (or variable) interest rate. that has attached coupons and pays periodic interest payments (usually annual or semi-annual) during the course of its life and par value

What are the benefits of owning or buying a zero-coupon bond over a traditional interest-paying bond?

Zero-coupon When the Federal Reserve cuts interest rates aggressively, Treasury bonds can rise dramatically. 1 Treasury zeros are frequently a great hedge for stock investors since these gains can more than balance stock-related losses. They also offer strong long-term returns, which are comparable to long-term Treasuries.