zero-coupon bond

(noun)

A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity.

Examples of zero-coupon bond in the following topics:

  • Zero-Coupon Bonds

    • A zero-coupon bond is a bond with no coupon payments, bought at a price lower than its face value, with the face value repaid at the time of maturity.
    • Examples of zero-coupon bonds include U.S.
    • Treasury bills, U.S. savings bonds, and long-term zero-coupon bonds.
    • This creates a supply of new zero coupon bonds.
    • Zero coupon bonds may be long- or short-term investments.

  • Valuing Zero-Coupon Bonds

    • The value of a zero-coupon bond equals the present value of its face value discounted by the bond's contract rate.
    • A zero-coupon bond with requires repayment of $100,000 in 3 years.
    • A zero-coupon bond is one that does not pay interest over the term of the bond.
    • Zero-Coupon Bond Value = Face Value of Bond / (1+ interest Rate)
    • It is important when completing the zero-coupon bond calculation to ensure the time period and term of the bond are expressed in similar terms.

  • Coupon Interest Rate

    • Not all bonds have coupons.
    • Zero-coupon bonds are those that pay no coupons and thus have a coupon rate of 0%.
    • Normally, to compensate the bondholder for the time value of money, the price of a zero-coupon bond will always be less than its face value on any date before the maturity date.
    • An example of zero coupon bonds is Series E savings bonds issued by the U.S. government.
    • A variation are stepped-coupon bonds, with a coupon that increases during the life of the bond.

  • Redeeming at Maturity

    • The journal entry to record the retirement of a bond: Debit Bonds Payable & Credit Cash.
    • A maturity date is the date when the bond issuer must pay off the bond.
    • Bonds can be classified to coupon bonds and zero coupon bonds.
    • For coupon bonds, the bond issuer is supposed to pay both the par value of the bond and the last coupon payment at maturity.
    • In case of a zero coupon bond, only the amount of par value is paid when the bond is redeemed at maturity.

  • Other Types of Bonds

    • Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
    • A variation is a stepped-coupon bonds, whose coupon increases during the life of the bond.
    • Zero-coupon bonds pay no regular interest.
    • Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating ("stripping off") the coupons from the principal.
    • In other words, the separated coupons and the final principal payment of the bond may be traded separately .

  • Reinvestment Risk

    • For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond.
    • Reinvestment risk affects the yield-to-maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased.
    • Maturity of the bond - The longer the maturity of the bond, the higher the likelihood that interest rates will be lower than they were at the time of the bond purchase.
    • Interest rate on the bond - The higher the interest rate, the bigger the coupon payments that have to be reinvested, and, consequently, the reinvestment risk.
    • Zero coupon bonds are the only fixed-income instruments to have no reinvestment risk, since they have no interim coupon payments.

  • Advantages of Bonds

    • In finance, a bond is an instrument of indebtedness of the bond issuer to the holders.
    • It is a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon).
    • Most individuals who want to own bonds do so through bond funds.
    • There are also a variety of bonds to fit different needs of investors, including fixed rated bonds, floating rate bonds, zero coupon bonds, convertible bonds, and inflation linked bonds.
    • It is a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon).

  • Calculating Yield to Maturity Using the Bond Price

    • If the yield to maturity for a bond is less than the bond's coupon rate, then the (clean) market value of the bond is greater than the par value (and vice versa).
    • If a bond's coupon rate is less than its YTM, then the bond is selling at a discount.
    • If a bond's coupon rate is more than its YTM, then the bond is selling at a premium.
    • If a bond's coupon rate is equal to its YTM, then the bond is selling at par.
    • Consider a 30-year, zero-coupon bond with a face value of $100.

  • Types of Bonds

    • Coupon bonds carry detachable coupons for the interest they pay.
    • These have a coupon that remains constant throughout the life of the bond.
    • A variation is stepped-coupon bonds, whose coupon increases during the life of the bond.
    • Also known as FRNs or floaters, these have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor.
    • Zeros pay no regular interest.

  • Floating-Rate Bonds

    • Floating rate bonds are bonds that have a variable coupon equal to a money market reference rate (e.g., LIBOR), plus a quoted spread.
    • Floating rate bonds (FRBs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread (i.e., quoted margin).
    • At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread.
    • There are many variations of floating-rate bonds.
    • A FRB has a duration close to zero, and its price shows very low sensitivity to changes in market rates.