Zero coupon bond

3 key takeaways

• Zero coupon bonds are sold at a discount and mature at face value.
• Investors earn a return from the difference between the purchase price and the face value at maturity.
• These bonds are often used for long-term investments and tax planning strategies.

What is a zero coupon bond?

A zero coupon bond is a debt security that does not make any interest payments (coupons) during its life. Instead, it is issued at a significant discount to its face value, and the investor receives the full face value when the bond matures. The difference between the purchase price and the face value represents the investor’s return on the bond.

For example, if a zero coupon bond has a face value of $1,000 and is issued at $600, the investor will receive $1,000 at maturity, with the $400 difference being the interest earned over the life of the bond.

How does a zero coupon bond work?

Zero coupon bonds work differently from traditional bonds that pay periodic interest. Here’s a breakdown of how they function:

• Purchase at discount: Investors buy zero coupon bonds at a price lower than their face value. The purchase price is based on the bond’s maturity period and the prevailing interest rates.
• No periodic interest: Unlike regular bonds, zero coupon bonds do not pay interest during their term. The investor does not receive any cash flow until maturity.
• Maturity payment: At maturity, the bondholder receives the full face value of the bond. The return on investment is the difference between the purchase price and the face value, effectively representing the accrued interest over the bond’s life.

Example

Consider a zero coupon bond with a face value of $1,000, maturing in 10 years. If the bond is sold at $620, the investor will receive $1,000 at maturity. The $380 difference ($1,000 – $620) is the interest earned over 10 years.

Advantages and disadvantages of zero coupon bonds

Advantages

• Predictable returns: The return is known at the time of purchase, as it is simply the difference between the purchase price and the face value.
• Tax planning: For some investors, particularly those in certain jurisdictions, zero coupon bonds can offer tax benefits since interest is not paid annually.
• Long-term savings goals: These bonds are suitable for long-term financial goals, such as saving for college education or retirement.

Disadvantages

• No periodic income: Investors do not receive regular interest payments, which might not be suitable for those needing steady income.
• Interest rate risk: If interest rates rise, the price of zero coupon bonds can fall, making them less attractive compared to new bonds issued at higher rates.
• Tax implications: In some jurisdictions, the imputed interest (the difference between purchase price and face value) may be taxed annually, even though no cash is received until maturity.

Applications of zero coupon bonds

Zero coupon bonds are often used in various financial strategies and by different types of investors:

• Education funding: Parents might invest in zero coupon bonds to match the bond’s maturity with the anticipated time their children will start college.
• Retirement planning: Investors can use these bonds to accumulate funds for retirement, benefiting from the compound interest over time.
• Corporate finance: Companies might issue zero coupon bonds to finance projects without the burden of making regular interest payments.

For further exploration, related topics include bond investing, discount bonds, treasury securities, and yield to maturity. These subjects offer deeper insights into different types of bonds and their roles in investment portfolios.