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 to above is also used for this Bonds.
Since there are no intermediate cash flows associated with such Bonds, these types of bondsTypes Of BondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. 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 RiskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. .
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:
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. is given as 8%.
Zero-Coupon Bond Value = [$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 interestCompound InterestCompound interest is the interest charged on the sum of the principal amount and the total interest amassed on it so far. It plays a crucial role in generating higher rewards from an investment. 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. of 8%.
Zero-Coupon Bond vs. Regular Coupon Bearing Bond
Here are the key differences between Zero-coupon Bond and Regular Coupon Bearing Bond
#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 InstrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes. 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.
#1- Illiquid Secondary Markets
Not all Zero-coupon Bonds have a ready secondary marketSecondary MarketA secondary market is where securities are offered to the general public after being offered in the primary market. Such securities are usually listed on the stock exchange. A significant portion of trading happens in such a market and are of two types – equities and debt markets., 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. 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. 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 –