Zero Coupon Bonds
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ZERO-COUPON BOND
Zero-coupon bonds are bonds that don’t pay any interest (also known as coupons) to the bondholder like typical bonds. The holder of a zerocoupon bond only receives the face value of the bond at maturity. The holder of a coupon-paying bond receives the face value of the bond at maturity but is also paid interest/coupon over the life of the bond. Now the question is that why a person should buy zero-coupon bond when it doesn’t pay any interest on the bond. Zero-coupon bonds are purchased at a large discount, known as deep discount, to the face value of the bond. A coupon-paying bond will initially trade near the price of its face value. In other words, a zero-coupon bond gains from the difference between the purchase price and the face value, while the coupon bond gains from the regular distribution of interest. So we can simply say that Zero-coupon bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity, which is the face value of the bond. For example, imagine that you have the choices between a oneyear zero-coupon bond with a face value of $1,000, which can be purchased for $952.38 or a one-year 5% semi-annual coupon bond trading at its face value of $1,000. If you bought the zero-coupon bond for $952.38, you would receive $1,000 at maturity, which is a gain of 5% ($47.62/$952.38). If you bought the coupon bond, you would have received two coupon payments of $25 each during the year for a total of $50, which also represents a 5% gain ($50/$1,000). So in this case, no matter which bond you buy, you will get the same return, even though the source of the return is different. But this is not always true, as each case is different. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, which means that if the inflation rises the money paid to the bond holder would be more than the face value of the zero-coupon bond, but the majority of zero coupon bonds pay a set amount of money, that is face value of the bond. Zero coupon bonds may be long or short-term investments. Longterm zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or until they are sold on secondary bond
markets. Short-term zero coupon bonds generally have maturities of less than one year and are generally called bills. There are some bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. This method of creating zero-coupon bond is known as stripping and the contracts are known as Strip Bonds.
Sources: http://www.investopedia.com/ask/answers/06/zerocouponregularbond.asp http://www.investopedia.com/terms/z/zero-couponbond.asp http://en.wikipedia.org/wiki/Zero-coupon_bond
Zero-coupon bonds are bonds that don’t pay any interest (also known as coupons) to the bondholder like typical bonds. The holder of a zerocoupon bond only receives the face value of the bond at maturity. The holder of a coupon-paying bond receives the face value of the bond at maturity but is also paid interest/coupon over the life of the bond. Now the question is that why a person should buy zero-coupon bond when it doesn’t pay any interest on the bond. Zero-coupon bonds are purchased at a large discount, known as deep discount, to the face value of the bond. A coupon-paying bond will initially trade near the price of its face value. In other words, a zero-coupon bond gains from the difference between the purchase price and the face value, while the coupon bond gains from the regular distribution of interest. So we can simply say that Zero-coupon bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity, which is the face value of the bond. For example, imagine that you have the choices between a oneyear zero-coupon bond with a face value of $1,000, which can be purchased for $952.38 or a one-year 5% semi-annual coupon bond trading at its face value of $1,000. If you bought the zero-coupon bond for $952.38, you would receive $1,000 at maturity, which is a gain of 5% ($47.62/$952.38). If you bought the coupon bond, you would have received two coupon payments of $25 each during the year for a total of $50, which also represents a 5% gain ($50/$1,000). So in this case, no matter which bond you buy, you will get the same return, even though the source of the return is different. But this is not always true, as each case is different. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, which means that if the inflation rises the money paid to the bond holder would be more than the face value of the zero-coupon bond, but the majority of zero coupon bonds pay a set amount of money, that is face value of the bond. Zero coupon bonds may be long or short-term investments. Longterm zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or until they are sold on secondary bond
markets. Short-term zero coupon bonds generally have maturities of less than one year and are generally called bills. There are some bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. This method of creating zero-coupon bond is known as stripping and the contracts are known as Strip Bonds.
Sources: http://www.investopedia.com/ask/answers/06/zerocouponregularbond.asp http://www.investopedia.com/terms/z/zero-couponbond.asp http://en.wikipedia.org/wiki/Zero-coupon_bond
