What is Compound Accreted Value (CAV)
Compound accreted value (CAV) is a measure of the theoretical value of a zero-coupon bond at any given point in time. zero-coupon bonds are usually long-term investments which do not yield interest payments as do traditional bonds. The interest of a zero-coupon bond accrues until maturity when it is paid. Therefore, the calculation of compound accreted value (CAV) is from adding all of the interest earned up to a given point in time to the original price of the bond.
Breaking Down Compound Accreted Value (CAV)
Put another way, the compound accreted value (CAV) of a zero-coupon bond would be equal to its principal plus accrued compound interest. With compound interest, the investment grows exponentially. This method of calculating interest is the reverse of simple interest, which increases linearly.
A zero-coupon bond does not pay regular interest but is offered at a deep discount. The investment vehicle gives the investor profit only at maturity when redemption will be for the full face value. With its delayed income, a zero-coupon bond that is purchased today and matures in 20 years won’t produce interest income in for two decades. A zero-coupon bond is also known as an accrual bond. Calculating the compound accreted value (CAV) would be necessary to determine the total value of the bond at any point before maturity.
How Compound Accreted Value Works
The initial principal amount added to the accretion on the current date will result in the CAV. For example, if a zero-coupon bond is purchased for $1,000 and matures at a rate of 10 percent annually, the CAV after ten years is $2,593.74. As the investment ages with compound interest, the principal which will be returned to the investor grows.
In some cases, the issuer may provide a schedule of compound accreted values to investors in an official statement. This document, prepared in connection with a primary offering includes relevant information, such as how the securities will be repaid and the financial characteristics of the issuer.
Calculating a zero-coupon bond's compound accreted value (CAV) becomes important if the bond carries a call provision. The call provision allows the issuer to buy back, or retire, the bond. This is because call provisions for zero-coupon bonds are typically linked to the bond's CAV. The provision will usually stipulate that the issuer can call the bond on a specific date at a price that is a premium to the bond's CAV.
A zero-coupon bond is trading at a premium if it costs more than its compound accreted value (CAV) at that specific point in time. Conversely, the zero-coupon bond is trading at a discount if it costs less than its CAV.