What it means
The structure is simple: pay less now, receive a fixed sum later. A bond that repays $100,000 in ten years might be bought today for around $61,000, and the $39,000 difference is the interest, compounded and delivered in one lump at the end.
The appeal for investors is certainty about a future amount, which suits anyone with a known obligation on a known date, such as a school fee, a pension payment or an insurance claim expected in fifteen years. There is also no reinvestment risk, because there are no coupons that might have to be reinvested at a lower rate.
For issuers the attraction is cash flow. A business or government can borrow now and pay nothing at all until maturity, which suits projects that generate no cash for several years, though the single repayment at the end can be uncomfortably large.
Price volatility is the main drawback. A zero coupon bond has a duration equal to its full term, so a ten year zero moves considerably more when rates shift than a ten year bond paying regular coupons, cutting both ways for the holder.
Tax is the other complication in many countries. Even though no cash is received, the annual accretion in value is often treated as taxable interest, so a holder can owe tax each year on income that will not arrive until maturity, which is why these bonds are frequently held inside tax sheltered accounts.
In practice
Real-world examples.
Example
A family knows it will need $50,000 for university fees in eight years. It buys zero coupon government bonds maturing that summer, fixing the amount that will be available regardless of what interest rates do in the meantime.
Example
A toll road operator issues zero coupon bonds to fund construction, matching the absence of interest payments to the four years before the road opens and starts collecting revenue.
Example
A pension scheme with a large payment due in 2041 buys zero coupon bonds maturing that year. The trustees accept the sharp price swings along the way because the bonds are held to maturity and the final amount is already known.
Think of it
“Zero coupon bond pays no interest-you buy at discount and get face value at maturity.
Formula
Calculation
Price = face value / (1 + yield)^number of years. Rearranged, yield = (face value / price)^(1 / number of years) - 1.
An investor buys a zero coupon bond that will repay $100,000 in exactly 10 years, at a market yield of 5%. The compounding factor is 1.05 raised to the power of 10, which equals 1.628895. Price = $100,000 / 1.628895 = $61,391.
The total return over the life of the bond is $100,000 - $61,391 = $38,609 on an outlay of $61,391. In the first year the value accretes by $61,391 x 0.05 = $3,070, and by the end of year five the bond is worth $100,000 / 1.05^5 = $78,353, still growing at 5% a year with no cash changing hands until the final repayment.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Kestrel Property Trust, an invented developer, funded a $60,000,000 site assembly with zero coupon bonds maturing in seven years, delighted that it would pay no interest at all while the scheme was in planning.
The bonds were issued at a yield of 8%, so the amount due at maturity was substantially more than the sum borrowed, and the accrued liability grew on the balance sheet every year. By year five the fictional trust's reported gearing had risen sharply even though not a dollar had left the business, and its bank covenants came under strain.
Kestrel's board eventually refinanced part of the debt with a conventional amortising loan two years before maturity, at a cost. The lesson its illustrative finance director drew was that zero coupon debt protects cash flow but does nothing for the balance sheet, and the repayment date needs planning for from day one.
Watch out
Common mistakes.
- Assuming a zero coupon bond earns nothing because it pays no interest, when the whole return is built into the discounted purchase price.
- Forgetting that many tax systems charge tax on the annual accretion in value even though no cash has been received.
- Treating a zero coupon bond as low risk because the payout is fixed, while ignoring how violently its market price moves if rates change before maturity.
Questions
People also ask.
How does an investor make money if there are no interest payments?
By buying below face value and receiving the full face value at maturity, with the difference representing compounded interest.
Are zero coupon bonds riskier than ordinary bonds?
Credit risk is arguably higher because everything depends on one payment at the end, and price risk is definitely higher because the duration equals the full term.
What is a strip?
A conventional bond that a dealer has separated into its individual coupon and principal payments, each of which then trades as its own zero coupon instrument.
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