What is a Zero-Coupon Bond?

A zero-coupon bond is like planting a cherry tree…

Planting vegetable gardens involves planting seeds and harvesting the vegetables later the same year. But when you plant a cherry tree, you’ll have to wait many years for fruit and make sure it survives during those years.. The fruit is sweeter, but you wait a long time. That’s how zero-coupon bonds work. You have to wait longer to get your money back, but assuming the company is successful , you should get back more than you paid for the bond.

A zero-coupon bond is a type of debt security that provides profit for the investor when it reaches maturity. Unlike traditional bonds, zero-coupon securities don’t provide interest payments during the life of the bond. Instead, investors make money on these bonds when they buy them at a deep discount.

Most bonds offer a recurring income stream for the investor. Corporations and government entities issue these bonds to investors and then pay coupon payments, often twice per year, until the bond reaches maturity. The size of the coupon payments depends on the bond’s interest rate, set at the time of issue.

With zero-coupon bonds, that’s not the case. Investors in these bonds don’t receive regular coupon payments throughout the life of the security. Instead, the return from these bonds comes as a result of buying them at a discount. The difference between the price someone buys a zero-coupon bond for and the face value payment the issuer must pay back at maturity is the bond’s yield.

Suppose a company issues bonds with a face value of $1,000 and a maturity date 10 years in the future. In the case of a traditional bond, the company might try to sell them for as close to face value as possible. Over the next 10 years, the issuing entity would make interest payments to investors. Then, when the bond reaches maturity, the company would pay each investor $1,000 for the bond.

But with a zero-coupon bond, it works a bit differently. The company would sell the bonds for significantly less than $1,000. But then the issuer wouldn’t make interest payments throughout the bond’s life. Instead, the investors would make a profit when they received the $1,000 when the bond matured.

If you’re looking for an investment that will provide fixed-income payments for the next 10 years, then a zero-coupon bond probably isn’t the right investment for you. Unlike most bonds, which do result in coupon payments, zero-coupon bonds don’t. The only return an investor will see from these bonds is when they reach maturity or if they are sold prior to maturity.

At first blush, one might wonder why would someone buy this type of bond given the lack of recurring income. In general, this type of investment can be attractive for someone who is saving for a large purchase that’s many years away. For example, someone might use a zero-coupon bond for investment purposes such as helping fund a kid’s college savings, or to help pay for that vacation home they hope to buy a decade or two down the road.

Just because you aren’t relying on interest income to make money from a zero-coupon bond doesn’t mean they are without their risks.

There are several factors that create risk for these debt securities. First, zero-coupon bond prices are sensitive to interest rates. As interest rates go up, zero-coupon bond prices tend to go down in the secondary market (a marketplace where investors can buy and sell securities). This risk only applies if you sell your bond before maturity.

One of the biggest risks of zero-coupon bonds is the default risk. With this type of bond, you have to wait until it reaches maturity to recoup any of your investment. So if the company defaults (or can’t pay back its financial obligations), you may not get all or some of your money back. With traditional bonds that pay coupon payments, investors at least receive periodic interest payments for a time, even if the issuer defaults.

Finally, there’s the risk that zero-coupon bonds won’t keep up with inflation. Suppose you wanted to use the returns of a zero-coupon bond to pay for your kid to go to college. When the child is born, you buy a bond with a maturity date that’s 18 years away. In the 18 years preceding 2021, the United States saw an average annual inflation rate of 2.10%. So if the yield of your bond didn’t exceed that inflation rate, then the money you spent on the bond 18 years ago is worth less than the money you got back when it reached maturity.

Unlike traditional bonds with coupon payments, the only income of zero-coupon bonds comes from the amount the bondholder receives at maturity. To figure out the yield on a zero-coupon bond, you’d figure out its yield to maturity (meaning the rate you’d get if you held it until it reached maturity). The formula for a zero-coupon bond yield to maturity is:

Let’s run a zero-coupon bond example through this formula. Suppose you had a zero-coupon bond with a face value of $1,000 and a current market price of $750. The bond will reach maturity in five years. First, you’d divide the face value of the bond by the price ($1,000 ÷ $750) with a result of 1.33.

Next, you’d calculate 1 ÷ n for this equation. N represents the number of years to maturity, so the result is 0.2. Now that we have those numbers, we can calculate 1.33 ^ 02, which equals 1.06. Finally, if we subtract 1 to finish the formula, we have a result of 0.06. Shown as a percentage, the yield to maturity of this particular zero-coupon bond is 6%.

Rather than calculating the yield to maturity of a bond, you can also calculate the discount price based on the yield. This type of calculation can be helpful if you know specific information such as the face value of the bond, and you have an interest rate in mind that you’d like to get from the bond. To calculate the price of a zero-coupon bond, you can use the following formula:

In this calculation, YTM is the interest rate you’d like to see from the bond, while n refers to the number of years until maturity. Suppose you wanted to buy a hypothetical zero-coupon bond, and require an interest rate of at least 5%. You know the face value of the bond is $1,000, and it has five years to maturity. You’d calculate (1 + 0.05) ^ 5, which comes to 1.28. Once you divide the face value of the bond by 1.28, you get a price of $781.25. This is what you must pay for the bond to see your desired rate of return.

For investors who want to look into zero-coupon bonds further, there are a few additional factors to consider:

1. If someone is investing in zero-coupon bonds, they should be sure to figure out what maturity date they’d like on a bond based on their individual needs.
2. An investor should decide the target rate of return they’d need to see to consider buying a zero-coupon bond.
3. Understand the tax ramifications of zero-coupon bonds. Depending on the type of bond, investors may need to pay income taxes on the accruing interest each year. This doesn’t apply to certain municipal zero-coupon bonds.
4. Once an investor is ready to buy a zero-coupon bond, they should contact their broker. Brokers are the financial professionals who facilitate these sales, usually for a fee or commission.