Definition
A Zero Coupon Bond is a type of debt security that does not make any periodic interest payments or “coupons.” Instead, it is issued at a significant discount to its face value. The investor’s return is realized through the bond’s appreciation, where the bond’s value increases as it approaches its maturity date, at which point it is redeemed at face value.
Key Features
No Periodic Interest Payments
Unlike traditional bonds that pay interest periodically, zero coupon bonds do not provide any interim cash flows. This means that the bondholder does not receive periodic interest payments, making it a “zero coupon” security.
Sold at a Discount
These bonds are sold for much less than their face (par) value. The difference between the purchase price and the face value at maturity accounts for the effective interest earned by the bondholder.
Appreciation of Value
The return on a zero coupon bond comes from the gradual appreciation of its value. As the maturity date approaches, the bond’s price moves closer to its face value. This appreciation is the bondholder’s profit.
Types of Zero Coupon Bonds
Treasury Strips
One common type of zero coupon bond is the Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities), which are created by separating the interest and principal payments of U.S. Treasury securities.
Municipal Zero Coupon Bonds
Certain municipalities issue zero coupon bonds, which are often used to fund long-term projects and are exempt from federal taxes.
Corporate Zero Coupon Bonds
Corporations may issue zero coupon bonds to raise capital, often providing higher yields than government-issued zero coupon bonds due to the higher risk associated with corporate debt.
Historical Context
Zero coupon bonds became popular in the 1980s when financial institutions began separating the interest and principal payments of traditional bonds, creating synthetic zero coupon bonds. This innovation allowed investors to tailor maturity dates and investment horizons more precisely.
Applicability
Zero coupon bonds are suitable for investors with specific long-term financial goals, such as saving for a child’s education or retirement. These bonds are beneficial for those who do not require periodic income and can wait until maturity for the return of their principal with interest.
Comparisons
Versus Coupon Bonds
Coupon bonds pay periodic interest payments to bondholders, while zero coupon bonds do not. The latter’s appeal lies in their simplicity and the potential for significant appreciation over time.
Versus Deep Discount Bonds
While all zero coupon bonds are deep discount bonds, not all deep discount bonds are zero coupon bonds. Deep discount bonds may pay periodic interest but are sold at a considerable discount due to perceived risk.
Related Terms
- Certificate of Accrual on Treasury Securities (CATS): A type of zero coupon bond created by stripping the interest from Treasury securities and selling the parts separately.
- Coupon Bond: A bond that pays periodic interest payments to the holder.
- Deep Discount Bond: A bond sold at a price significantly lower than its face value.
- Original Issue Discount (OID): The difference between the face value of a bond and its original issue price when sold at a discount.
FAQs
What is the main advantage of a zero coupon bond?
How is the interest on a zero coupon bond calculated?
Are zero coupon bonds taxable?
Summary
Zero coupon bonds are unique investment vehicles that offer no periodic interest payments and are sold at a deep discount to their face value. They provide investors with returns through the bond’s appreciation over time, making them suitable for long-term financial goals. Understanding their features, benefits, and risks is essential for making informed investment decisions.
References
- Fabozzi, Frank J. “The Handbook of Fixed Income Securities.” McGraw-Hill Education, 2012.
- Bodie, Zvi, Kane, Alex, and Marcus, Alan J. “Investments.” McGraw-Hill Education, 2013.
