What is a Zero-Coupon Bond?

A bond is a debt instrument issued by the government or by a company. It promises to make routine payments (coupon payments) to the holder. A zero-coupon bond, as the name implies, does not pay a coupon (interest). So, why would people buy a zero-coupon bond? Basically, the bond is sold at a significant discount from its face value. The trading value goes up as the bond approaches its priority date. The priority date is the date on which the bonds face value will be payable. At that date, the bond will pay its full, face value. For this reason, zero-coupon bonds are often referred to as an accrual bond. Many zero-coupon bonds are sold under those conditions. In other cases, a regular corporate bond is stripped of its interest payment by the company issuing the bond. The bonds are reclaimed and repackaged as zero-coupon bonds.

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How Does a Zero-Coupon Bond Work?

Bonds are methods for companies to raise capital. Bond purchasers are lenders to the company. The company is the debtor. Most bonds pay interest (a coupon) annually or semi-annually throughout the duration of the bond. When the bond reaches a maturity date (the end of the bond period), the holder is entitled to receive the face value (a stated amount) of the bond. Many bonds (like the zero-coupon bond) do not pay regular interest payments. These types of bonds are sold at the time of issuance for an amount less than face value. This is known as selling the bond at a discount. For example, a $10 bond may be sold for $9. At the end of 1 year, the bond will pay the holder $10. Effectively, the bondholder earned $1 on a $9 investment for one year. In the above example, the $1 is the investors return. The amount of interest or coupon received includes the principle paid for the bond and interest (which is compounded annually or semi-annually) at a stated yield. Unlike the regular, coupon-paying bonds, a zero-coupon bond has an imputed interest rate (rather than an established interest rate). To illustrate, if a bond with a face value of $1,000 matures in 20 years with a 5.5% annual yield, can be purchased at $3,378. This represents $1,000 in value in 20 years if the money compounds annually for 20 years. The bondholder must pay federal (an potentially state) income taxes on the bond coupon payments. On a zero-coupon bond, the bondholder has imputed income. This is also known as phantom income, as the bondholder does not actually receive any funds.

Calculating the Price of a Bond

Below is the formula for calculating the present value of a zero coupon bond: Price = M / (1 + r)^n where M = the date of maturity r = Interest Rate n = # of Years until Maturity If an investor wishes to make a 4% return on a bond with $10,000 par value due to mature in 2 years, he will be willing to pay: $10,000 / (1 + 0.04)^2 = $9,245. So, the bond is being sold at 92% of its face value.