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 do I calculate the holding period return yield on a zero-coupon bond?

    Learn how to calculate the holding period return yield for a zero-coupon bond based on a formula with a relevant example ... Read Answer >>
  3. Why do interest rates tend to have an inverse relationship with bond prices?

    At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer ... Read Answer >>
  4. What is a stripped bond?

    The quick answer to this question is that a stripped bond is a bond that has had its main components broken up into a zero-coupon ... Read Answer >>
  5. What is the formula for calculating the capital to risk weight assets ratio for a ...

    Learn about the Macaulay duration and zero-coupon bonds, the formula used for the calculation and how to calculate the Macaulay ... Read Answer >>
  6. 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 >>
Related Articles
  1. Investing

    All About Zero Coupon Bonds

    Zero-coupon bonds are bonds that do not make any interest payments (which investment professionals often refer to as the "coupon") until maturity. For investors, this means that if you make an ...
  2. 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 ...
  3. Investing

    How Do I Calculate Yield To Maturity Of A Zero Coupon Bond?

    Yield to maturity is a basic investing concept used by investors to compare bonds of different coupons and times until maturity.
  4. Personal Finance

    ‘Retired’ Too Soon? How to Reenter the Workforce After 50

    Here's what you need to know to survive financially and reenter the workforce when you're over 50 and a layoff has forced you to "retire" too soon.
  5. Investing

    Corporate Bonds: Advantages and Disadvantages

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

    An Introduction to Individual Bonds

    Individual bonds are better than bond funds and can be a key component to one’s investment strategy.
  7. 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.
RELATED TERMS
  1. Coupon Stripping

    The separation of a bond's periodic interest payments from its ...
  2. Zero-Coupon Bond

    A debt security that doesn't pay interest (a coupon) but is traded ...
  3. Zero-Coupon Convertible

    A fixed income instrument that is a combination of a zero-coupon ...
  4. Bond

    A debt investment in which an investor loans money to an entity ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Deferred Interest Bond

    A debt instrument that pays interest only upon maturity. Unlike ...
Hot Definitions
  1. Money Market

    A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. ...
  2. Block (Bitcoin Block)

    Blocks are files where data pertaining to the Bitcoin network is permanently recorded.
  3. Fintech

    Fintech is a portmanteau of financial technology that describes an emerging financial services sector in the 21st century.
  4. Ex-Dividend

    A classification of trading shares when a declared dividend belongs to the seller rather than the buyer. A stock will be ...
  5. Debt Security

    Any debt instrument that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount ...
  6. Taxable Income

    Taxable income is described as gross income or adjusted gross income minus any deductions, exemptions or other adjustments ...
Trading Center