Zero Coupon Bond

What Is A Zero Coupon Bond?

Zero coupon bonds are bonds that pay no interest at regular intervals like traditional bonds do. Rather, zeros are sold at a deep discount to their maturity or face value. As the bonds get closer to their face value over time, they accumulate interest, and the investor receives the full face amount at maturity.

For example, a zero coupon bond with a face value of US$1,000 due in 20 years will be offered at a price of US$200. The difference between the US$200 offering price and the eventual US$1,000 maturity value is the accumulated interest.

By contrast, a traditional US$1,000 bond with a 3% coupon is offered at US$1,000, and the investor receives coupon payments equivalent to 3% every year until the bond matures, at which time the investor gets his US$1,000 back.

Zero coupon bonds allow investors to pay a sharp discount to the eventual maturity value of the bond. As such, they are often used to finance a large purchase that is many years in the future, such as a college education or retirement expenses. Zeros are most popular in high interest rate environments because investors are able to lock in a high rate for a long period of time.

The best example of a zero coupon bond is a U.S. Treasury bill, which is sold at a discount and investors get the face amount when the bill matures.^[1]

Risks Of Zero Coupon Bonds

In addition to the risk of default, traditional bonds face two main types of risk: Reinvestment risk and interest rate risk. Zeros don't face reinvestment risk but they do face interest rate risk.

Reinvestment risk is the risk that the investor won't be able to reinvest his bond's coupon payments at the same rate as the coupon rate. For example, if the bond pays a 3% coupon but market interest rates have since fallen to 2%, the bond's overall return will suffer. Since their rate is locked in to maturity, zeros don't face that risk.

However, zeros, like traditional bonds, do face price risk. If the zero investor needs to sell her bond prior to maturity, the price she gets for it may be less than she expected if interest rates have risen in the meantime. For example, if the zero bond has an imputed interest rate of 3% but market rates have since climbed to 4%, she will have to reduce the price of the bond to attract a prospective buyer.^[2]

Tax Consequences

Although zeros don't pay interest, investors are still responsible for paying income taxes on any "imputed" interest they earn each year, even if they haven't actually received it.^[3]

Summary

Zero coupon bonds are bonds that pay no interest during their lifetimes, unlike traditional coupon bonds. Rather, zeros are sold at a deep discount to their face or maturity value, and the difference between the price and their maturity value is the interest.