Zero Coupon Bond

What is Zero Coupon Bond?

Zero-Coupon Bond (Also known as Pure Discount Bond or Accrual Bond) refers to those bonds which are issued at a discount to its par value and makes no periodic interest payment, unlike a normal coupon-bearing bond. In other words, its annual implied interest payment is included in its face value which is paid at the maturity of such bond. Therefore this bond is the one where the sole return is the payment of the nominal value on maturity.

Explanation

These Bonds are initially sold at a price below the par value at a significant discount, and that’s why the name Pure Discount Bonds referred to above is also used for this Bonds.

Since there are no intermediate cash flows associated with such Bonds, these types of bondsTypes Of BondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more don’t result in reinvestment risk because there are no cash flows prior to maturity that must be reinvested.

Such bonds possess the greatest duration, which is equivalent to the maturity of such bonds and, as such, are subject to the greatest level of Interest Rate Risk.

Since the Interest accrued is discounted from the Par value of such Bonds at purchase, which effectively enables Investors of Zero Coupon Bonds to buy a greater number of such bonds compared to any other Coupon Bearing Bond.

Zero-Coupon Bond Formula

we can calculate the Present value of using this below-mentioned formula:

Zero-Coupon Bond Value =Maturity Value/(1+i)^ Number of Years

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For eg:
Source: Zero Coupon Bond (wallstreetmojo.com)

Example

Let’s understand the concept of this Bond with the help of an example:

Cube Bank intends to subscribe to a 10-year this Bond having a face value of $1000 per bond. The Yield to MaturityYield To MaturityYield to Maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's expected returns after making all the payments on time throughout the life of a bond.read more is given as 8%.

Accordingly,

Zero-Coupon Bond Value = [$1000/(1+0.08)^10]

zero coupon bond

= $463.19

Thus the Present Value of Zero Coupon Bond with a Yield to maturity of 8% and maturing in 10 years is $463.19.

The difference between the current price of the bond, i.e., $463.19, and its Face Value, i.e., $1000, is the amount of compound interestCompound InterestCompound Interest is the interest earned from the initial Principal & the previously accumulated Interest amount. This is also known as “Interest on Interest” & it is always higher than the Simple Interest. read more that will be earned over the 10-year life of the Bond.

Thus Cube Bank will pay $463.19 and will receive $1000 at the end of 10 years, i.e., on the maturity of the Zero Coupon Bond, thereby earning an effective yieldEffective YieldEffective yield is a yearly rate of return at a periodic interest rate proclaimed to be one of the effective measures of an equity holder's return as it takes compounding into its due consideration, unlike the nominal yield method.read more of 8%.

Zero-Coupon Bond vs. Regular Coupon Bearing Bond

Here are the key differences between Zero-coupon Bond and Regular Coupon Bearing Bond

Basis Zero-Coupon Bond Regular Coupon Bearing Bond
MeaningIt refers to fixed IncomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more security, which is sold at a discount to its Par value and doesn’t involve any cash flow during the life of the Bond except on maturity.It refers to fixed Income security, which involves regular payment in the form of coupons and may be issued at a discount or premium depending upon market dynamism.
CouponsNo Interest Coupons during the lifetimeRegular Coupons semi-annually or annually.
DurationThe duration of a Zero-coupon Bond is equal to the maturity of the Bond.The duration of the Regular bond will always be less than its maturity.
Interest Rate RiskInvolves the greatest level of Interest Rate Risk due to the high duration of the BondDuration Of The BondDuration is a risk measure used by market participants to measure the interest rate sensitivity of a debt instrument, e.g. a Bond. It tells how sensitive is a bond with respect to the change in interest rates. This measure can be used for comparing the sensitivities of bonds with different maturities. There are three different ways to arrive duration measures, viz. Macaulay Duration, Modified Duration, and Effective Duration.read more.Comparatively less than Zero Coupon Bond.
Reinvestment RiskThere is no Reinvestment Risk Reinvestment Risk Reinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity.read morein a Zero-coupon Bond as there are no cash flows during the life of the Bond.Suffers from Reinvestment Risk due to regular cash flow in the form of coupon payments during the life of the Bond.

Advantages

#1  Predictability of Returns

This offers predetermined returns if held till maturity, which makes them a desirable choice among investors with long term goals or for those intending assured returns and doesn’t intend to handle any type of Volatility usually associated with other types of Financial Instruments such as Equities etc.

 #2 – Removes Reinvestment Risk

These Bonds avoid the risk of Reinvestment of Coupon Bonds as Interest Rates keep changing with the passage of time, which impacts the Yield to Maturity of such coupon-bearing Bonds. Since there are no interim cash flows, the investor is assured of a fixed rate of return.

#3 – Longer Time frame

Usually, these Bonds are issued for a longer time frame, which can be used by a potential investor to align with their life goals such as Marriage, Children Education, and retirement, and so on. Thus a smart investor based on their time horizon can invest in different maturity Zero-coupon Bonds by paying a smaller amount initially (as Zero-coupon Bonds are issued at deep discounts, one can buy more with lesser amount) and stagger them as per their career and life goals without getting impacted by the volatility.

Disadvantages

 #1- Illiquid Secondary Markets

Not all Zero-coupon Bonds have a ready secondary market, which results in illiquidity. Furthermore, in case of any urgent need funds, it is difficult to liquidate the same without getting a major haircut in value.

#2 – High Duration and Interest Rate Risk

They have a single cash inflow for the Investor, which happens at the maturity, and as such, these bonds have the greatest Duration, which results in Interest Rate Risk. Further, These are issued with call provisions that allow the issuer of such Bonds to redeem the bonds prior to their maturity at dates and prices, which are predetermined at the time of the issue of such Bonds. In such cases, the Investor is left with the risk of reinvestingReinvestingReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio.read more the proceeds at the rates available at the time of redemption, which will obviously be less than the earlier slated yield on the redeemed bonds.

#3 -No Regular Income

It doesn’t offer any regular source of income and is a complete misfit for those looking for a stable regular source of Income. Furthermore, one has to pay tax on the accrued interestAccrued InterestAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period.read more on such bonds every year. However, it is pertinent to note here that there are certain categories of Zero Coupon Bonds, which can overcome the taxation problem.

This has been a guide to what is Zero Coupon Bond. Here we discuss how to calculate Zero Coupon Bond using its pricing formula along with its advantages and disadvantages and practical examples. You can learn more about from the following articles –

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