Zero-coupon bond

Definition

A zero-coupon bond is a type of bond that does not pay periodic interest (coupon payments) to the bondholder. Instead, it is sold at a discount to its face value, and the investor receives the face value of the bond when it matures.

What are zero-coupon bonds?

Here are some key points about zero-coupon bonds:

1. No periodic interest payments:
– Unlike traditional bonds, zero-coupon bonds do not make regular interest payments to the bondholder. Instead, they are issued at a discount and pay out a lump sum at maturity.

2. Discounted purchase price:
– Investors purchase zero-coupon bonds at a price below their face value. The discount represents the interest that would have been paid over the life of a traditional bond.

3. Face value at maturity:
– When the bond reaches its maturity date, the issuer pays the bondholder the full face value, which is the amount the bond was originally intended to be worth.

4. Fixed maturity date:
– Zero-coupon bonds have a fixed maturity date, at which point the bondholder receives the face value. The time to maturity is typically long-term, ranging from several years to several decades.

5. Implied yield:
– The yield on a zero-coupon bond is implied by the difference between its purchase price and face value. This implied yield is the effective interest rate the investor earns over the life of the bond.

6. Less price volatility:
– Zero-coupon bonds tend to have less price volatility compared to traditional bonds because they do not make coupon payments, which can be affected by changes in market interest rates.

7. Tax considerations:
– Even though zero-coupon bonds do not make regular interest payments, investors may have to pay taxes on the imputed interest that accrues each year. This is known as “phantom income.”

8. Uses for investors:
– Zero-coupon bonds are often used for specific financial goals, such as funding a child’s education or planning for retirement. Because they provide a known future value, they can be a useful tool for long-term financial planning.

9. Types of issuers:
– Zero-coupon bonds can be issued by governments (treasury STRIPS) or corporations. They may also be created through financial institutions that “strip” the coupon payments from a regular bond to create zero-coupon bonds.

10. Risk considerations:
– While zero-coupon bonds offer a fixed return at maturity, there is some risk associated with holding them, particularly if the issuer defaults. Investors should assess the creditworthiness of the issuer before investing.

11. Illiquid nature:
– Zero-coupon bonds are generally less liquid than other types of bonds since they do not trade as frequently. This means that selling them before maturity may be more challenging.

Overall, zero-coupon bonds provide a way for investors to lock in a known future value, making them a useful tool for specific financial goals. However, investors should carefully consider the implications, including tax treatment and risk factors, before investing in these instruments.

Example of zero-coupon bonds

Imagine you’re an investor interested in purchasing bonds. You come across a zero coupon bond issued by XYZ Corporation, which has a face value of £1,000 and a maturity period of 5 years.

Let’s say the zero coupon bond issued by XYZ Corporation is currently trading at £800 in the market. As an investor, you purchase this bond for £800.

Over the next 5 years, you hold onto the zero coupon bond without receiving any interest payments. At the end of the 5-year maturity period, XYZ Corporation repays the bond’s face value of £1,000 to you.

By purchasing the zero coupon bond at a discounted price of £800 and receiving £1,000 at maturity, you earn a return of £200 over the 5-year period.