Zero Coupon Bond

What is a Zero Coupon Bond?

A Zero Coupon Bond is a type of bond issued at a significant discount to its face (par) value. However, it does not pay periodic interest (coupons). Instead, investors earn the return on their investment when the bond matures, and they receive its full face value. This unique characteristic makes zero coupon bonds especially appealing for certain investment strategies, particularly for those looking for long-term investment growth without the need for annual income.

Key Characteristics

• Issued at a Discount: Zero coupon bonds are sold at a price significantly lower than their face value.
• No Periodic Interest Payments: Unlike traditional bonds, zero coupon bonds do not pay interest (coupons) throughout their life.
• Pays at Maturity: The only payment is received at maturity, which equals the face value of the bond.

Examples

1. U.S. Savings Bonds: These are typically zero coupon bonds issued by the U.S. Department of the Treasury.
2. Stripped Treasury Bonds: Also known as STRIPS, these are traditional bonds that have had their principal and interest payments separated, effectively creating zero coupon bonds.
3. Corporate Zero Coupon Bonds: Companies may issue these bonds to raise capital, where bondholders receive the face value at maturity instead of regular interest payments.

Frequently Asked Questions

How does one calculate the yield of a zero coupon bond?

The yield of a zero coupon bond can be calculated using the following formula:

\[ \text{Yield} = \left( \frac{\text{Face Value}}{\text{Purchase Price}} \right)^{\frac{1}{n}} - 1 \]

where \( n \) is the number of years until maturity.

Why would an investor choose a zero coupon bond?

An investor might choose a zero coupon bond for several reasons such as:

• Long-term maturity dates that can match future financial goals (e.g., retirement, college tuition).
• Value is less affected by reinvestment risk (the risk that the proceeds from interest payments will not be able to be reinvested at the same rate).

What is the tax treatment of zero coupon bonds?

For tax purposes, the gradual increase in the bond’s value is considered implicit interest and must be reported as income, even though no actual interest is received during the bond’s tenure. This is known as “phantom income.”

Are zero coupon bonds riskier than regular bonds?

Zero coupon bonds may carry higher interest rate risk because they don’t pay periodic interest. If interest rates rise, the bond’s price may fall more dramatically than that of bonds that pay regular interest.

What are the investment risks associated with zero coupon bonds?

• Interest Rate Risk: The bond’s price is more sensitive to changes in interest rates.
• Reinvestment Risk: There is no reinvestment of periodic coupon payments since there are none.
• Credit Risk: If the issuer defaults, the bondholders may not receive the face value at maturity.

Related Terms

• Bond: A debt security where the issuer is obligated to pay periodic interest and repay the principal at maturity.
• Deeply Discounted Security: Securities that are sold at a significant discount to their face value.
• Coupon Stripping: The process of separating the interest (coupon) payments from the principal, resulting in zero coupon bonds.

Online References

• Investopedia: Zero Coupon Bond
• U.S. Securities and Exchange Commission (SEC): Types of Bonds
• The Balance: What Is a Zero-Coupon Bond?

Suggested Books for Further Studies

1. “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi: A comprehensive guide covering different types of bonds and investment strategies.
2. “Fixed Income Analysis” by Barbara S. Petitt, Jerald E. Pinto: Useful for understanding the valuation and analysis of fixed-income securities.
3. “The Strategic Bond Investor: Strategies and Tools to Unlock the Power of the Bond Market” by Anthony Crescenzi: Insightful for investors looking to optimize their bond investments, including zero coupon bonds.

Accounting Basics: “Zero Coupon Bond” Fundamentals Quiz

Thank you for exploring the fundamentals of zero coupon bonds and tackling our quiz questions to enhance your understanding of this unique investment vehicle!