What Is Compound Accreted Value (CAV)?
Compound accreted value (CAV) is a measure of the value of a zero-coupon bond at a point in time prior to its maturity date. The CAV is calculated by taking its original purchase price and adding the accrued interest previously earned by the bondholder.
CAV is a useful metric for bond investors. In addition to signifying the current value of the bond, CAV can also be useful for determining whether the bond issuer is likely to call the bond. If the bond is called, this would force the bondholder to sell the bond back to the issuer, receiving a cash payment equal to the bond’s CAV.
- Compound accreted value (CAV) is a measure of the value of a zero-coupon bond.
- It is often used to calculate the value of such bonds prior to their maturity date.
- Bond issuers sometimes provide investors with a schedule of projected CAVs over the course of the bond’s term. This information can be useful to anticipate whether the bond is likely to be called by the issuer.
How CAV Works
CAV is widely used among buyers and sellers of zero-coupon bonds. These unique investment vehicles do not pay interest during their term, but instead accrue interest that is paid out at the bond’s maturity date. Put differently, zero-coupon bonds provide a return to investors by allowing them to purchase the bond at a substantial discount to its face value.
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. This can help investors quickly understand the projected value of the bond over the course of its term, as well as the creditworthiness of the borrower.
Calculating a zero-coupon bond's CAV becomes especially 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 CAV at that specific point in time. Conversely, the zero-coupon bond is trading at a discount if it costs less than its CAV.
Real World Example of CAV
To illustrate, consider the case of a 10-year zero-coupon bond with an interest rate of 10% per year. Because it is a zero-coupon bond, this instrument would not actually pay out its interest each year. Instead, the investor would simply receive a large buyout at the end of year 10 reflecting the accumulated interest that was earned (or “accrued”) throughout that time. Assuming an original purchase price of $1,000, for instance, this 10-year bond would pay out $2,593.74 at the end of its term. In other words, the bond’s CAV at the end of year 10 would be $2,593.74.
If the investor wants to sell their bond before the end of the term, then the bond would be valued at its CAV, which is equal to the purchase price of the bond plus any accrued interest that has been earned up to that point in time. If, for instance, the investor sells the bond at the end of year 5, then its CAV would be $1,610.51. Likewise, the CAV would be lower if the bond were sold earlier, and it would be larger if it were sold later in the term.