Zero-coupon bonds do not offer periodic interest payments like coupon bonds. They offer zero-interest payments periodically. The only cash inflow for the investor comes at the bond maturity through principal repayment. These bonds are issued at a deep discount to attract investors since they do not offer periodic interest payments.
A zero-coupon bond is a debt instrument and it pays no periodic interest. This bond is traded at a deep discount to its face value.
US treasury bills are a prime example of zero-coupon bonds. These bonds are also called discount bonds. These bonds can be issued with zero interest from the beginning. In some cases, bond issuers can transform existing bonds into zero-coupon bonds as well. Either way, the investors receive their repayment at maturity only. Since these bonds do not offer period coupon payments, they tend to fluctuate more in prices with interest rate changes.
How Does Zero-Coupon Bond Work?
Large companies, corporations, and government institutes regularly issue bonds to raise capital financing. Investors make returns through interest payment and higher market value of bonds than their face value. Bonds that make interest payments are called coupon bonds. Some bonds are issued without a pledge to periodic interest payments. These bonds are called to as zero-coupon bonds.
The bond issuer offers a deep discount on the value of this bond to attract investors. Since bonds are marketable securities, investors can trade zero-coupon bonds are higher prices later in the secondary market. Investors can hold the bonds to maturity to receive their return on investment through principal repayment.
The investors must be compensated with a greater face value of their investment today. Since they do not receive interest payments, they must be offered a deep discount that compounds to the face value of the bond at maturity. All bonds are issued at a discount to their face value. For example, a coupon bond with a face value of $1,000 can be traded at $950. If the investor trades the bond at a market value immediately, it earns a $50 profit. Similarly, bond issuers need to make deeper discounts to zero-coupon bonds to attract investors.
Special Consideration with Zero-Coupon Bonds
Zero-coupon bonds do not make periodic interest payments to investors. It does not imply these bonds do not consider the interest computation for investor’s money at stake. The price calculation of these bonds considers the interest factor as well. The compensated repayment at maturity includes the principal and interest factor for the investor. The interest calculated this way is called imputed interest.
The formula to calculate the market value of the zero-coupon bond is:
Price = M / (1+r) n
Where M = face value or maturity value of the bond
R = required rate of interest
N = number of years
Suppose a bond issuer needs to issue a zero-coupon bond with a face value of $10,000 with 10 years of maturity. The investors’ expected rate of return is 5%. We can calculate the price of the bond as follow:
Price = $10,000 / (1+5%) 10
Price = $ 6,139.133
Since zero-coupon bonds do not make periodic interest payments, they do not offer reinvestment risk. However, these bonds carry higher interest rate risks as they come with a long maturity period.
Advantages of Zero-Coupon Bonds
Zero-coupon bonds offer several benefits to issuers and investors.
- These bonds are less volatile and offer predictable returns to investors.
- Investors are assured of fixed income at maturity, so it eliminates the reinvestment risk as there are no periodic repayments.
- These bonds require a low initial investment.
- Investors can use these bonds for long-term financial goals as these bonds compound interest over a long period.
- These bonds are often issued with call features by the issuers.
Disadvantages of Zero-Coupon Bonds
Zero-coupon bonds come with several limitations as well. Some of the disadvantages with these bonds include:
- These bonds tend to carry higher interest rate risks.
- These bonds do not offer periodic and regular income to investors.
- If the issuers call the bond, the bondholder may face the reinvestment risk as well.
- Without coupon payments, these bonds are considered illiquid instruments in the secondary markets.
- The income on zero-coupon bonds through imputed interest is taxable in many jurisdictions including the guidelines from the IRS.
- These bonds are more suitable to investors looking for long-term financial goals only.
Zero-coupon bonds do not offer periodic interest payments. These bonds are issued at a deep discount to investors. Investors receive only one large cash inflow at maturity. These bonds are more suitable for investors with long-term financial goals. However, these bonds carry higher interest rate risks.