Loading the player...

What is a 'Zero-Coupon Bond'

A zero-coupon bond is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

Some zero-coupon bonds are issued as such, while others are bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price much more than coupon bonds.

A zero-coupon bond is also known as an accrual bond.

BREAKING DOWN 'Zero-Coupon Bond'

A bond is a portal through which a corporate or governmental body can raise capital. When a bond is issued, investors purchase the bonds, and in effect, act as lenders to the issuing entity. The investors earn a return in the form of coupon payments made annually or semi-annually throughout the life of the bond. When the bond matures, the bondholder is repaid an amount equal to the face value of the bond. The par or face value of a corporate bond is usually stated as $1,000. If a corporate bond is issued at a discount, this means investors can purchase the bond below its par value. For example, an investor that purchases a bond at a discount for $920 will receive $1,000. The $80 return plus coupon payments received on the bond is the investor's earnings or return for holding the bond.

But not all bonds have coupon payments. Such bonds are referred to as zero coupon bonds. These bonds are issued at a deep discount and repaid the par value at maturity. The difference between the purchase price and the par value represents the investor's return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. The interest earned on a zero-coupon bond is an imputed interest, meaning that it is an estimated interest rate for the bond, not an established interest rate. For example, a bond with a face amount of $20,000 maturing in 20 years with a 5.5% yield may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,757 (or $13,243) represents the interest that compounds automatically until the bond matures.

The imputed interest on the bond is subject to income tax, according to the Internal Revenue Service (IRS). So, although no coupon payments are made on zero coupon bonds until maturity, investors may still have to pay federal, state, and local income taxes on the imputed or phantom interest that accrues each year. Purchasing a municipal zero coupon bond, buying zero coupon bonds in a tax-exempt account, or purchasing a corporate zero coupon bond that has tax-exempt status are a couple of ways to avoid paying income taxes on these securities.

Calculating Price

The price of a zero coupon bond can be calculated as:

Price = M / (1 + r)n

where M = maturity date

r = required rate of interest

n = number of years until maturity

If an investor wishes to make a 6% return on a bond with $25,000 par value due to mature in 3 years, he will be willing to pay:

$25,000 / (1 + 0.06)3 = $20,991.

If the debtor accepts this offer, the bond will be sold to the investor at $20,991 / $25,000 = 84% of the face value. Upon maturity, the investor gains $25,000 - $20,991 = $4,009, which translates to 6% interest per year.

The greater the length of time until the bond matures, the less the investor pays for it, and vice versa. The maturity dates on zero coupon bonds are usually long term, with many having initial maturities of at least 10 years. These long-term maturity dates can allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the bond's deep discount, an investor can put up a small amount of money that can grow over many years.

Investors can choose zero coupon bonds that are issued from a variety of sources, including the U.S. Treasury, state/local government entities, and corporations. Most zero coupon bonds trade on the major exchanges.

RELATED TERMS
  1. Bond Valuation

    Bond valuation is a technique for determining the theoretical ...
  2. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  3. Bond Discount

    Bond discount is the amount by which the market price of a bond ...
  4. Straight Bond

    A straight bond is a bond that pays interest at regular intervals, ...
  5. Coupon Rate

    Coupon rate is the yield paid by a fixed income security, which ...
  6. Deferred Interest Bond

    Deferred interest bond is a debt instrument that pays interest ...
Related Articles
  1. Investing

    Comparing Yield To Maturity And The Coupon Rate

    Investors base investing decisions and strategies on yield to maturity more so than coupon rates.
  2. 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.
  3. Investing

    All about zero coupon bonds

    Learn everything you always wanted to know about these debt instruments, which pay no interest until maturity.
  4. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  5. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  6. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
  7. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
RELATED FAQS
  1. How do debit spreads impact the trading of options?

    Find out what it means when a bond has a coupon rate of zero and how a bond's coupon rate and par value affect its selling ... Read Answer >>
  2. How do I calculate yield to maturity of a zero-coupon bond?

    Find out how to calculate the yield to maturity of a zero-coupon bond, and learn why this calculation is simpler than one ... Read Answer >>
  3. How does an investor make money on bonds?

    Bonds are part of fixed-income securities called debt obligations, meaning one party borrows from another party who expects ... Read Answer >>
Hot Definitions
  1. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  2. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  3. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  4. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  5. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  6. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
Trading Center