Zero-Coupon Bond

A bond that pays no interest and is usually paid to the bondholder at face value on the maturity date.

A zero-coupon bond (ZCB) is a bond that pays no interest and is usually paid to the bondholder at face value on the maturity date. Investors profit by buying bonds at a discount to their face value. They can be issued with a discount added or a bank stripped of the coupon and packaged as these bonds.

Bonds are classified according to the payment method. The types of bonds are zero-coupon bonds, discount bonds, interest-bearing bonds, fixed-rate bonds, and floating-rate bonds.

Common zero-coupon bonds, such as short-term U.S. Treasury bonds and multiple ZCBs obtained by splitting the interest and principal of ordinary long-term bonds, are called strip bonds.

Since 1985, the U.S. Treasury Department has issued STRIPS (Separate Trading of Registered Interest and Principal of Securities), obtained by splitting medium and long-term government bonds.

These bonds have a wide range of applications. For example, they can determine the forward rate and calculate U.S. Treasury bonds' interest rate term structure.

ZCBs is a relatively common innovation in financial instruments which does not pay interest. However, changes to the tax code have affected the market's enthusiasm for it. Like treasury savings bonds, they are sold at a steep discount to par value.

When the bond matures, the bond's face value is the summation of interest and purchase price. These bonds are very volatile and are included in the investor's taxable income even though no interest is earned in cash on the investment.

Understanding these bonds

A ZCB is issued at a price lower than the par value when published and is paid at the par value when redeemed. Its interest is implied between the issue price and the redemption price.

The most prominent feature of these bonds is to avoid the risk of reinvestment of the interest earned by investors.

A ZCB is a bond that pays no dividends, and investors can buy it at a discount (that is, at a price below par) and receive par value at maturity. Because of these properties, these bonds are susceptible to changes in interest rates. 

Characteristics of such a bond are:

  1. Such bonds are issued at a discount below the face value, and the issuance discount rate determines the interest rate of the bonds;
  2. The redemption period of this type of bond is fixed. After maturity, the bond is repaid at face value of the bond, with no interest payment problem.
  3. The yield of such bonds is pre-determined and attractive to investors;
  4. This type of bond also has certain advantages in taxation. For example, according to the laws of many countries, such bonds can avoid tax on interest income.

Purpose

A new type of bond appeared in the 1980s: "zero coupons," which have no coupon and do not pay interest.

In effect, investors already receive interest when they purchase such bonds. These bonds generally have longer maturities, up to 20 years. It is issued at a discount to the face value, and investors are paid at face value of the bond on the maturity date.

Example:

A 20-year bond with a face value of $20,000 will likely be issued for only $6,000. 

In addition, there are special ZCBs operated by brokerage companies in foreign countries, which are issued independently by the brokerage company after stripping the coupon and principal from each other.

Brokerage firms Merrill Lynch, Pierce, and Fowler Smith, created a zero-coupon bond, guaranteed by the U.S. government, with a separate principal and coupon, issued at a deep discount.

The idea is to offer the option to buy a bond at a price below its face value. In return for paying this reduced rate early, bondholders will receive an interest rate that will ultimately yield a return at least equal to par value and possibly a little more.

These bonds are an excellent way to raise funds for projects expected to generate profits before the bond's maturity date, as they are considered one of the safest forms of bond issuance.

How to price these Bonds?

These types of bonds are discounted securities that pay no interest over the life of the loan and are purchased at a discount to the face value redeemed at maturity. Capital appreciation is the difference between the bid price and the face value redeemed at maturity.

Bid Price = Fave Value - Capital Appreciation

The price of a ZCB can be calculated as

Present Value (PV) = FV(1+r)t

Yield-to-Maturity = (FVPV))1/t-1

  • PV = Present Value
  • FV = Future Value
  • r = Yield-to-Maturity (YTM), required rate of interest
  • t = Number of compounding periods until maturity

There exist calculators for such bond yields, which can be used to calculate the holding period and holding-maturity annualized yield of one-time principal and zero-coupon bonds, including simple and compound interest

"One-off principal and interest bond" and "zero-coupon bond" will not receive interest during the holding period. Instead, the principal and interest of the former will be paid in one lump sum at maturity, and the latter's income will be implied at maturity according to the bond face value in the principal paid. 

The yield is calculated at simple interest or compound interest for the one-time principal-interest bond and ZCB with a pending repayment period of one year or less.

Tip: The annualized rate of return is a theoretical rate that converts the rate of return during the investment period (such as days, months, and years) into a one-year rate of return through the compound interest algorithm.

Advantages and disadvantages

A few of the advantages and disadvantages are:

Advantages:

The company pays no or only a tiny amount of interest every year. According to the tax law, the discount amount when the ZCB or low-coupon bond is issued can be amortized among the taxable persons of the company.

Unlike the common bond, a zero-coupon bond does not need to pay interest but trades at a discount (lower than par value), which gives the investor profit at the maturity date when they redeem the bond for full par value.

Disadvantages:

Bonds that mature with an outlay of cash are much more significant than when the bond was issued; such bonds are usually not redeemable early. Therefore, the company cannot ask bond investors to sell the bonds back to the company if market interest rates fall.

This type of bond does not pay interest to its investors, and investors might need to wait a long period to receive their share of the interest. In addition, these bonds do not provide fixed cash flows, implying the investor's income is excluded from the market.

Additionally, these bonds have a higher risk, so investors would like to invest in this type of bond issued by the government rather than companies.

Differences between Zero-Coupon Bond & Discount Bonds

Among the common types of bonds, zero-coupon and discount bonds are more typical. 

A discount bond refers to a short-term discount bond, which is issued at a discount rate at a price lower than the face value at the time of issuance. However, the principal is still repaid at face value at maturity without additional interest.

From the interest payment method perspective, zero coupon and discount bonds are discount bonds issued at a discount. The difference between those two is the length of the term.

Generally, the duration of discount bonds is shorter, such as short-term treasury bills, while ZCBs linger much longer, up to 20 years.

Unlike other bonds, ZCBs are issued at a discount lower than the face value, so the discount rate is the bond yield. After the holding expires, the zero-coupon bonds are fully redeemed, and no additional interest is paid.

During the period, no matter whether the interest rate rises or falls, the zero-coupon bonds cannot be redeemed in advance, and the discount rate remains unchanged. 

Because of this, if the market interest rate falls, the company issuing the zero-coupon bond has no right to ask the bond investor to sell the bond back to the company.

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Researched and Authored by Yihan Du | LinkedIn

Reviewed and Edited by Parul Gupta | LinkedIn

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