What is a Zero Coupon Bond?
Zero-coupon bonds, also known as accrual bonds, are debt securities that trade at significant discounts without paying interest and make a profit at maturity when the bond is redeemed for par value.
- Zero coupon bonds are a non-interest-paying debt guarantee.
- Zero Coupon Bonds are traded at significant discounts and offer par value (par value) profits at maturity.
- The difference between the purchase price and the par value of a zero coupon bond indicates the investor’s return.
Understand Zero Coupon Bonds
Some bonds are issued as zero-coupon bonds from the beginning, while others are converted to zero-coupon bonds after the financial institution removes the coupon and repackages it as a zero-coupon bond. Zero coupon bonds tend to fluctuate in price more than coupon bonds because they offer the full amount at maturity.
Bonds are a portal for businesses or government agencies to raise funds. When bonds are issued, investors buy those bonds and effectively act as lenders to the issuer. Investors earn returns in the form of semi-annual or annual coupon payments for the life of the bond.
When a bond matures, the bondholder will be repaid equal to the face value of the bond. The par value of corporate bonds is usually stated at $ 1,000. If the bond is issued at a discounted price, this means that the investor can buy the bond below its par value. For example, an investor who buys a bond at a discount of $ 920 will receive $ 1,000. The $ 80 return and the payment of the coupon received on the bond are the return on the investor’s return or holding the bond.
However, not all bonds are paid coupons. Those that do not are called zero coupon bonds. These bonds are issued at a significant discount and will be repaid at par at maturity. The difference between the purchase price and the par value represents the investor’s return. The payment received by the investor is equal to the invested principal plus the interest earned at a fixed yield, compounded semi-annually.
The interest earned on zero coupon bonds is imputed interest. In other words, this is the estimated interest rate on the bond, not the established interest rate. For example, a bond with a par value of $ 20,000, a maturity of 20 years, and a yield of 5.5% can be purchased for about $ 6,855. At the end of 20 years, investors will receive $ 20,000. The difference between $ 20,000 and $ 6,855 (or $ 13,145) represents interest that is automatically combined until the bond expires. Attributive interest is sometimes referred to as “phantom interest”.
According to the Internal Revenue Service (IRS), interest attributable to bonds is subject to income tax. Therefore, no coupon payments will be made for zero-coupon bonds until maturity, but investors may be required to pay federal, state, and local income tax on their annual imputed interest. Buying a local government zero-coupon bond, buying a zero-coupon bond in a tax-exempt account, or buying a zero-coupon bond for a company with tax exemption status is some way to avoid paying income tax on these securities.
Zero Coupon Bond Pricing
The price of a zero coupon bond can be calculated as follows:
Price = M ÷ (1 + r)NS
- M = bond maturity or face value
- r = required interest rate
- n = number of years to maturity
If an investor wants to earn 6% of a $ 25,000 par bond that is due to mature in three years, he is ready to pay:
$ 25,000 / (1 + 0.06)3 = $ 20,991.
If the debtor accepts this offer, the bond will be sold to the investor for $ 20,991 / $ 25,000 = 84% of face value. At maturity, investors will earn $ 25,000- $ 20,991 = $ 4,009. This is equivalent to an annual interest rate of 6%.
The longer a bond matures, the less the investor pays for it, and vice versa. Zero coupon bonds usually have a long maturity, with an initial maturity of at least 10 years. These long maturities allow investors to plan long-term goals such as savings for their children’s college education. Significant bond discounts allow investors to invest small amounts of money that may grow over time.
Zero coupon bonds can be issued from a variety of sources, including the US Treasury, state and local governments, and businesses. Most zero coupon bonds are traded on major exchanges.
Zero-coupon bonds are similar to other bonds in that they carry various types of risks because investors are exposed to interest rate risk if they sell them before maturity.
How are zero coupon bonds different from regular bonds?
Interest or coupon payments are the main distinguishing factor between zero coupons and regular bonds. Regular bonds, also known as coupon bonds, pay interest over the life of the bond and repay the principal at maturity. Zero-coupon bonds do not pay interest and instead trade at significant discounts, benefiting at maturity when investors redeem the bonds for par value.
How do investors price zero coupon bonds?
Investors choose zero-coupon bonds that they want to buy based on several criteria, one of which is the imputed interest rate that can be earned at maturity. The price of zero coupon bonds can be calculated by the following formula.
Zero Coupon Bond Price = Maturity ÷ (1 + Required Interest Rate) ^ Number of Years to Maturity
Does the Hoe IRS tax zero coupon bonds?
The imputed interest rate, sometimes referred to as the “phantom interest rate,” is the estimated interest rate. Interest attributable to bonds is subject to income tax. The IRS uses the addition method in calculating the imputed interest on government bonds and has an applicable fed funds rate that sets a minimum interest rate in relation to the imputed interest and the original issuance discount rule.