A:

The difference between a zero-coupon bond and a regular bond is that a zero-coupon bond does not pay coupons, or interest payments, to the bondholder while a typical bond does make these interest payments. The holder of a zero-coupon bond only receives the face value of the bond at maturity. The holder of a coupon paying bond receives the face value of the bond at maturity but is also paid coupons over the life of the bond.

Zero-coupon bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity. Zero-coupon bonds are purchased at a large discount, known as deep discount, to the face value of the bond. A coupon-paying bond will initially trade near the price of its face value. In other words, a zero-coupon bond gains from the difference between the purchase price and the face value, while the coupon bond gains from the regular distribution of interest.

For example, imagine that you have the choices between a one-year zero-coupon bond with a face value of $1,000, which can be purchased for $952.38 or a one-year 5% semi-annual coupon bond trading at its face value of $1,000. If you bought the zero-coupon bond for $952.38, you would receive $1,000 at maturity, which is a gain of 5% ($47.62/$952.38). If you bought the coupon bond, you would have received two coupon payments of $25 each during the year for a total of $50, which also represents a 5% gain ($50/$1,000). So in this case, no matter which bond you buy, you will get the same return, even though the source of the return is different. This is not always true, as each case is different.

RELATED FAQS
  1. How does an investor make money on a zero coupon bond?

    Learn about investing in zero-coupon bonds, exactly how they work as an investment vehicle, and their advantages and disadvantages ... Read Answer >>
  2. How does a bond's coupon interest rate affect its price?

    Find out why the difference between the coupon interest rate on a bond and prevailing market interest rates has a large impact ... Read Answer >>
  3. Can the marginal propensity to consume ever be negative?

    Find out when a bond's yield to maturity is equal to its coupon rate, and learn about the basic components of bonds and how ... Read Answer >>
  4. How does the money from the interest on my bond get to me?

    When you buy a regular coupon bond, you are entitled to a coupon, which is typically paid at regular intervals, and the face ... Read Answer >>
  5. What are the key factors that will cause a bond to trade as a premium bond?

    Learn about the primary factor that can cause bonds to trade at a premium, including how national interest rates affect bond ... Read Answer >>
  6. What is the difference between yield to maturity and the coupon rate?

    Read about some of the basic differences between a debt security's coupon rate and its yield to maturity, and learn which ... Read Answer >>
Related Articles
  1. Investing

    Zero-Coupon Bond

    A zero-coupon bond or ‘no coupon’ bond is one that does not disburse regular interest payments. Instead, the investor buys the bond at a steep discount price; that is, at a price ...
  2. Investing

    How Are Zero-Coupon Municipal Bonds Taxed?

    What every investor needs to know about taxes and zero-coupon muni bonds.
  3. Financial Advisor

    Using Excel PV Function to compute Bonds PV

    To determine the value of a bond today - for a fixed principal (par value) to be repaid in the future at any predetermined time - we can use an Excel spreadsheet.
  4. Investing

    Corporate Bonds: Advantages and Disadvantages

    Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
  5. Investing

    Comparing Yield To Maturity And The Coupon Rate

    Investors base investing decisions and strategies on yield to maturity more so than coupon rates.
  6. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  7. Investing

    What is a Premium Bond?

    A premium bond is one that trades above its face or nominal amount.
  8. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
RELATED TERMS
  1. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  2. Bunny Bond

    A type of bond that offers investors the option to reinvest coupon ...
  3. Coupon Bond

    A debt obligation with coupons attached that represent semiannual ...
  4. Bond Discount

    The amount by which the market price of a bond is lower than ...
  5. Compound Accreted Value - CAV

    A measure of the theoretical value of a zero-coupon bond at any ...
  6. Municipal Convertible

    A zero-coupon municipal bond that can be converted into an interest-bearing ...
Hot Definitions
  1. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  2. Derivative

    A security with a price that is dependent upon or derived from one or more underlying assets.
  3. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  4. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
  5. Death Taxes

    Taxes imposed by the federal and/or state government on someone's estate upon their death. These taxes are levied on the ...
  6. Retained Earnings

    Retained earnings is the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested ...
Trading Center