DEFINITION of Zero-Coupon Convertible
A zero-coupon convertible is a fixed income instrument that combines a zero-coupon bond and a convertible bond. Due to the zero-coupon feature, the bond pays no interest and is issued at a discount to par value, while the convertible feature means that the bond is convertible into common stock of the issuer at a certain conversion price.
BREAKING DOWN Zero-Coupon Convertible
Zero-coupon convertibles have two features – zero-coupons and convertibles. A zero-coupon security is a debt instrument which does not make interest payments. An investor purchases this security at a discount and receives the face value of the bond on the maturity date. Because there are no payments prior to maturity, zero-coupons have no reinvestment risk. A convertible security is a debt instrument that can be converted into equity of the issuing company at a given time. The embedded put option that gives bondholders the right to convert acts as a sweetener for investors who get to participate in any upside in the price of the issuer’s stock.
A zero-coupon convertible is, thus, a non-interest paying bond that can be converted into the equity of the issuing company after the stock reaches a certain price. A zero-coupon convertible can also refer to a zero-coupon issued by a municipality that can be converted to an interest-paying bond at a certain time before the maturity date. When a municipal government issues these convertibles, they are tax-exempt, but are also convertible to other bonds that may yield more.
An investor who purchases this security pays a discount for the lower risk of these bonds but foregoes any interest income. These bonds have a lower risk than purchasing pure equity, given that the underlying shares of zero-coupon convertibles have high volatility. However, these financial instruments have a built-in option which allows the issuer to force the conversion of the bonds when the stock performs as expected, capping the investor’s upside potential. In addition, zero-coupon convertibles tend to be somewhat volatile in the secondary market because the convertible option may or may not become valuable, depending on how the company performs over the life of the debt instrument.
The zero-coupon and convertible features offset each other in terms of the yield required by investors. Zero-coupon bonds are often the most volatile fixed-income investments because they have no periodic interest payments to mitigate the risk of holding them; as a result, investors demand a slightly higher yield to hold them. On the other hand, convertibles pay a lower yield compared to other bonds of the same maturity and quality because investors may be willing to pay a premium for the convertible feature.
The issuer of zero-coupon convertible increases the principal of the convertible security each year to compensate investors for the absence of coupons. A zero-coupon convertible and interest-paying convertible with identical maturity and call provisions will have approximately the same conversion premium in spite of the difference in compensation to bondholders.
Zero-coupon convertibles are priced using option pricing models such as Black-Scholes; tree-based models such as the binomial or trinomial model; or the dividend valuation model. The underlying share price, assumptions about the behavior of the price, assumed equity valuation, and an assumed volatility level are inputs required to price the security. Due to the complexity of zero-coupon convertibles, only sophisticated investors trade them.