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.

RELATED TERMS
  1. Convertibles

    Securities, such as bonds, that can be turned into common stock ...
  2. Convertible Bond

    A convertible bond is a bond that can be converted into a predetermined ...
  3. Busted Convertible Security

    A busted convertible security is a convertible bond where the ...
  4. Deferred Equity

    Deferred equity is a security, such as preferred shares or convertible ...
  5. Premium Put Convertible

    A premium put convertible is a debt security which allows the ...
  6. Convertible Security

    A convertible security is an investment that can be changed into ...
Related Articles
  1. Investing

    All about zero coupon bonds

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

    An Introduction to Convertible Bonds

    Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex than they really are.
  3. Investing

    3 Best High-Yielding Convertible Bond ETFs (CWB, ICVT)

    Discover how convertible bond ETFs can offer investors growth and income while hedging fixed income portfolios in a rising rate environment.
  4. Investing

    3 Best High-Yielding Convertible Bond Mutual Funds (LACFX, FACVX)

    LACFX,FACVX,VCVSX: Learn about three of the highest-yielding options available.
  5. Investing

    The Top 3 Convertible Bond ETFs for 2016 (CWB, ICVT)

    Obtain detailed information on the exchange-traded funds (ETFs) available for traders seeking ETF exposure to convertible bond investments.
  6. Investing

    Leverage Your Returns With A Convertible Hedge

    Find out how you can maintain your income stream by using this type of bond strategy.
  7. Managing Wealth

    The Mandatory Convertible: A "Must Have" For Your Portfolio?

    Mandatory convertibles are a little understood security with some distinct advantages. Find out if they are right for you.
  8. Investing

    Introduction to Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
RELATED FAQS
  1. What is the difference between a zero-coupon bond and a regular bond?

    A zero-coupon bond does not pay coupons or interest payments like a typical bond does; instead, a zero-coupon holder receives ... Read Answer >>
  2. Why would a corporation issue convertible bonds?

    Discover how corporations issue convertible bonds to take advantage of much lower interest rates as a result of a conversion ... Read Answer >>
  3. Do convertible bonds have voting rights?

    Convertible bonds usually have no voting rights until they are converted. Even after conversion, they may not be granted ... Read Answer >>
  4. Why do interest rates have an inverse relationship with bond prices?

    At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer ... Read Answer >>
Hot Definitions
  1. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  2. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  3. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  4. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  5. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  6. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
Trading Center