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. Bond

    A bond is a fixed income investment in which an investor loans ...
  3. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  4. Coupon Rate

    Coupon rate is the yield paid by a fixed income security, which ...
  5. Zero-Coupon Mortgage

    A zero coupon mortgage is a long-term commercial mortgage that ...
  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

    Corporate Bonds: Advantages and Disadvantages

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

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  4. Investing

    Simple Math for Fixed-Coupon Corporate Bonds

    A guide to help to understand the simple math behind fixed-coupon corporate bonds.
  5. Investing

    Corporate Bond Basics: Learn to Invest

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

    6 Ways That Investors Use Bonds

    Learn how the stodgy stereotype of bonds can overshadow the basic and advanced uses of what these investments can do for your portfolio.
  7. Investing

    4 basic things to know about bonds

    Learn the basic lingo of bonds to unveil familiar market dynamics and open to the door to becoming a competent bond investor.
RELATED FAQS
  1. When is a bond's coupon rate and yield to maturity the same?

    Find out when a bond's yield to maturity is equal to its coupon rate, and learn about the components of bonds and how they ... 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 >>
  4. 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 >>
Trading Center