A bond's coupon rate is the percentage of its face value payable as interest each year. A bond with a coupon rate of zero, therefore, is one that pays no interest. However, this does not mean the bond yields no profit. Instead, a zero coupon bond generates a return at maturity. Bond investors look at a number of factors when assessing the potential profitability of a given bond. The key factors that influence a bond's profitability are its face value, or par, its coupon rate, and its selling price.
The par value of a bond is the stated value at issuance, usually $100 or $1,000. The coupon rate is largely dependent on federal interest rates. This means that, as interest rates go up or down, the market value of bonds fluctuates depending on if their coupon rates are higher or lower than the current interest rate.
For example, a $1,000 bond issued with a 4% coupon rate pays $40 in interest annually regardless of the current market price of the bond. If interest rates go up to 6%, newly issued bonds with a par of $1,000 pay annual interest of $60, making the 4% bonds less desirable. As a result, the market price of the 4% bond drops to entice buyers to purchase it, despite its lower coupon rate.
A zero coupon bond generally has a reduced market price relative to its par value because the purchaser must maintain ownership of the bond until maturity to turn a profit. A bond that sells for less than its par value is said to sell at a discount. Zero coupon bonds are often called discount bonds due to their reduced prices.
While generating income from this type of investment requires a bit more patience than the bond's interest-bearing counterparts, zero coupon bonds can still be highly lucrative. In addition, these types of bonds are simple, low-maintenance investment options, enabling investors to plan for long-term savings goals by investing relatively small sums that grow over a longer period of time.
(For related reading, see "How Does a Bond's Coupon Interest Rate Affect Its Price?")