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.
The price of a zero coupon bond can be calculated as:
Price = M / (1 + r)n
where M = Maturity value or face value of the bond
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 three 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.