What is a zero-coupon bond? (Benefits and examples)
By Indeed Editorial Team
Published 11 April 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Purchasing zero-coupon bonds can be an effective way of improving your investment skills and portfolio. This relatively low-risk method of investing allows you to predict your payout and support organisations that want to raise money to invest in growth. Understanding zero-coupon bonds is essential for beginner investors that want to buy bonds at a deep discount. In this article, we answer, 'What is a zero-coupon bond?', provide a formula to calculate the price of a bond of this type and share important benefits and drawbacks of investing in zero-coupon bonds.
What is a zero-coupon bond?
Learning the answer to, 'What is a zero-coupon bond?' is essential to gaining relevant trading knowledge and understanding of how the stock market and other market types function. A zero-coupon bond, also known as a discount bond or an accrual bond, renders a profit at maturity. Debt security of this specific type doesn't pay interest and instead trades at a deep discount, which is how it assumes a positive time value of money. This means the amount that the investor receives equals the difference between the price at which they purchased a bond and its par value.
Related: How to become an investment banker
Zero-coupon bond formula
In some instances, you may want to price a zero-coupon bond. To do this, it's necessary that you know the face value, which is the future value of the bond, also known as the maturity value. Here's the formula you can use, which assumes that here's an annually compounded interest rate:
Price of bond = face value / (1 + r)ª
r = rate of return or interest rate
a = number of years until maturity
Examples of zero-coupon bonds
Reviewing how zero-coupon bonds can influence your investments or a company's finances can help you better understand the concept behind bonds of this type. Here are some examples of zero-coupon bonds:
Annual compounding example
You're thinking about purchasing a zero-coupon bond with a face value of £1,500 that reaches maturity within 3 years. The bond has an annual interest rate of 5%. Here's how you can calculate how much you'd pay for the bond today:
Price of bond = £1,500 / (1 + 0.05)³ = £1,295.76
This means that if you want to buy this bond today, you'd pay £1,295.76 for it.
Semi-annual compounding example
You can also decide to calculate the price of a zero-coupon bond with semi-annual compounding. To calculate the price with semi-annual compounding, use the same information about the bond as in the previous example. You can then determine the current price of the bond using this formula:
Price of bond = £1,500 / (1 + 0.05 / 2)³×² = £1,293.46
Difference between regular and zero-coupon bonds
To fully understand zero-coupon bonds, it's necessary that you learn how they're different compared to regular bonds. The main difference is that if you're a holder of a regular bond, you're paid interest on what the bond makes. It also repays the principal amount of money you paid for it when it reaches maturity. When you're a holder of a zero-coupon bond, the bond doesn't pay you any interest, which means you simply receive its face value when it reaches maturity.
Advantages of zero-coupon bonds
For some investors, zero-coupon bonds are better because they can be more cost-effective than regular bonds. Here are common advantages of zero-coupon bonds:
Higher interest rate
It's common for zero-coupon bonds to have a higher interest rate than other types of bonds. This is because they don't generate regular payments for bondholders. As a result, to make the bond more attractive to potential investors, issuers may, for example, offer bonds with higher yields than regular bonds.
Payout is easier to predict
One of the most important advantages of zero-coupon bonds that seems the most attractive to many investors is their predictability. Zero-coupon bonds guarantee payments for the bondholders once the bond reaches maturity. Investing in zero-coupon bonds may be more cost-effective and attractive for investors with specific financial goals in mind, who can invest over a long time.
Disadvantages of zero-coupon bonds
Before making the decision to invest in zero-coupon bonds, it's critical to understand their common disadvantages and risks. Here are the possible drawbacks of zero-coupon bonds:
They're more sensitive to interest rates
Although investors usually wait until the bond reaches maturity to get a payout, it's also possible to do it early. When you decide to sell the bond before it reaches maturity, it's important to realise that its price is very sensitive to interest rate fluctuations. Usually, the price of zero-coupon bonds falls as the interest rate increases. These price swings can make these bonds less cost-effective when you sell them early.
When you invest in zero-coupon bonds, some countries may require you to pay taxes for the interest you haven't received yet, which is also known as phantom income. For example, when a country has both federal and state taxes, it may expect you to pay both for the phantom income. Although there are ways to avoid this, it's necessary for investors to be aware of this risk.
It's important that you realise the risk of the bond defaulting. When this occurs, it can make your investment impossible to claim. When you're investing in corporate zero-coupon bonds, it's important to be aware of this risk. To prevent this from happening, it's essential that you choose a company that has a strong credit rating, which significantly minimises the risk of this type.
Types of investing in bonds
Investing in bonds can be a great way when you want to invest in a company that you believe can succeed in the market. For those companies, issuing bonds is a proven technique to raise money to grow and expand. If you're considering investing in bonds, there are two ways in which you can do it:
Selling when they reach maturity
The first type of investing in bonds assumes that you hold your bonds until they reach maturity. After that, you can simply sell them at their face value and collect interest payments on them. It's a great strategy, especially for less experienced bondholders who want to invest in bonds long-term.
Related: How do investment banks make money?
Selling at a higher price
The second method of investing in bonds involves selling your bonds at a price that's higher than what you paid for them. Although this can help you make more from that investment, it's usually a riskier strategy. It's because it involves monitoring trends in the market to determine when to sell.
How to effectively invest in bonds
Reaching a point where you notice that your investments are successful may take some time, especially when you're just starting as an investor. Here are three things you can do to increase the chances of making a successful investment:
1. Learn more about the issuer
The first thing to do when you're considering investing in bonds is to determine if the issuer, which is the company that issues bonds, can pay its bonds. Although it's not always possible, in most cases, you can effectively estimate if a company can meet its financial and debt obligations. To do that, it's necessary that you choose a company that has a high rating according to leading rating agencies. Essentially, this rating shows you the creditworthiness of a bond.
2. Determine if it's the right time to buy bonds
Since interest rates can impact the bond's price fluctuations, it's important to make sure that it's the right time to purchase those bonds. If you've just started investing, it may be a good idea for you to purchase your bonds when their prices are simply the lowest and sell them when they arise. As you gain experience, you may also try to predict those price fluctuations and invest at different times, depending on the result of the investment that you want to achieve.
3. Decide if the bonds are a good fit for your portfolio
Depending on your financial situation or risk tolerance, there are different types of bonds that you may consider purchasing. Common types of bonds to consider include corporate, federal and municipal bonds. Investing in all three types may be helpful when you want to diversify your portfolio and reduce principal investment risk.
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