Zero-coupon bond

DEFINITION of Zero-coupon bond

Zero-coupon bond doesn’t make interest payments. Instead, they are issued at a discount to face value and mature at face value.

WHAT IT IS IN ESSENCE

A Zero Coupon Bond is a debt security that is sold at a discount and does not pay any interest payments to the bondholder. In other words, it’s a bond that sells for less than its face value and does not make coupon payments or periodic interest payments during its life. At maturity, it can then be redeemed at its face value allowing the bondholder to make a profit.

For example, a bond with a face value of $1000 might be issued at a price of 50 cents on the dollar. The yield is a function of the purchase price, the face value and the time remaining till maturity.

Because zero-coupon bonds provide no cash flow prior to maturity, their duration is equal to their maturity. Coupon-bearing bonds have durations shorter than their maturities. The longer duration of a zero means it has more interest-rate sensitivity than a coupon-bearing bond of the same maturity. It will rise in price faster when interest rates are falling, and fall faster when interest rates are rising.

HOW TO USE

As the name suggests, the issuer has no obligation to make any interest payments during the term of the bond. Only at maturity must the issuer repay the face value of the bond.

The investors aren’t willing to pay the same amount for a zero coupon bond that they would for a bond that pays interest. Zero coupon bonds are therefore sold at a discount to their face value. For instance, a 10-year one priced when prevailing yields were 3% would typically get auctioned for roughly $750 per $1,000. The $250 difference would essentially represent the interest over that time frame, but the bondholder wouldn’t actually receive cash until the maturity 10 years from now.

Instead of paying regular interest payments, it pays them in one lump sum at maturity.

There are two very different reasons why various investors like them.