Definition of a Zero Coupon Bond
A zero coupon bond is a type of debt security that does not pay regular interest payments. These bonds are useful for investors who need a set sum of money in the far distant future. They are also popular with bond traders trying to profit from changes in interest rates. Zero coupon bonds offer some unique features that may benefit some investors.
Other People Are Reading
-
Function
-
A zero coupon bond does not produce interest payments. Instead it sells at a deep discount of the face value. An investor's earnings come from the difference between the price paid for the bond and the face value amount received when the bond matures. For example, a 20-year Treasury zero coupon bond could be purchased in June 2010 for a price of 43.367. This means a zero coupon bond that pays $100,000 in 2030 would cost $43,367 in 2010 with the quoted yield on this bond of 4.24 percent.
Types
-
According to the Securities and Exchange Commission, zero coupon bonds are issued and available from all types of bond issuers, including municipal governments, corporations and the U.S. Treasury. Zero coupon bonds usually start with long maturities of 10 to 30 years. U.S. Treasury zero coupon bonds are the most widely traded and available in a wide range of maturities.
-
Considerations
-
Zero coupon bonds, issued by the Treasury, are referred to as "separate trading of registered interest and principal securities" or strips. Strips are created when the interest payments are "stripped" from Treasury bonds, and the future interest payments and principal are sold as zero coupon bonds. For example, a $10 million, 20-year Treasury bond with a 5 percent coupon will pay $250,000 in interest every six months. The 40 interest payments and the final principal payment can be separated, divided and sold as future principal payments for zero coupon Treasury bonds with a 20-year range of maturity.
Potential
-
Zero coupon bonds can be used to provide a specific amount of money for a set need in the future. Since the interest earned is in the discounted price, an investor does not have to find other places to invest the interest as would be the case with an interest paying, coupon bond. Zero coupon bonds also have the greatest price changes when interest rates change. Bond prices increase when interest rates decline, and traders use long-term zero coupon bonds to obtain the maximum profits when interest rates fall.
Warning
-
The market value of zero coupon bond will also decline the most if interest rates increase. In a rising rate environment, zero coupon bond investors are stuck with holding the bond until maturity or selling for a loss. Also, even though zeros do not pay interest directly, they earn imputed interest according to the tax code, and income tax may be due on the interest that accrues each year on a zero coupon bond.
-
