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.
- 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 above is also used for Zero Coupon Bonds.
- Since there are no intermediate cash flows associated with such Bonds these types of bonds 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 the Zero Coupon Bond using the below-mentioned formula:
Example of Zero Coupon Bond
Let’s understand the concept of a Zero Coupon Bond with the help of an example:
Cube Bank intends to subscribe to a 10-year Zero Coupon Bond having a face value of $1000 per bond. The Yield to Maturity is given as 8%.
Zero Coupon Bond Value Formula = [$1000/(1+0.08)^10]
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 interest 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 yield 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|
|Meaning||It refers to fixed Income 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.|
|Coupons||No Interest Coupons during the lifetime||Regular Coupons semi-annually or annually|
|Duration||Duration of a Zero-coupon Bond is equal to the maturity of the Bond.||Duration of the Regular bond will always be less than its maturity.|
|Interest Rate Risk||Involves the greatest level of Interest Rate Risk due to the high duration of the Bond.||Comparatively less than Zero Coupon Bond.|
|Reinvestment Risk||There is no Reinvestment Risk in 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 of Zero Coupon Bonds
#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 of Zero Coupon Bonds
#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, most Zero Coupon Bonds are issued with call provisions which 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 issue of such Bonds. In such cases, the Investor is left with the risk of reinvesting 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
Zero Coupon Bonds 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 interest 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 –