A zero-coupon bond is a type of financial instrument that does not make periodic interest payments like traditional bonds. Instead, it is issued at a discount to its face value and redeemed at the face value when it matures. The return to the investor is the difference between the purchase price and the face value, and this return is realized at maturity.
Here are the key characteristics of zero-coupon bonds:
- No Periodic Interest Payments: Unlike regular bonds, zero-coupon bonds do not make periodic interest payments to investors. Instead, the entire return comes from the difference between the purchase price and the face value.
- Issued at a Discount: Zero-coupon bonds are typically issued at a significant discount to their face value. The discount represents the interest that accumulates over time. The greater the time to maturity, the deeper the discount.
- Maturity Value: The face value of the bond, also known as the par value, is the amount the investor receives when the bond matures. This is the principal amount that was initially borrowed.
- Compounding Interest: Although zero-coupon bonds don’t make periodic interest payments, they do accrue interest, which is compounded until maturity. The compounding effect results in the bond appreciating in value over time.
- Fixed Maturity Date: Zero-coupon bonds have a fixed maturity date when the investor receives the face value. The maturity period can range from a few months to several years.
- Tax Treatment: In some jurisdictions, investors may be required to pay taxes on the imputed interest or accrued income each year, even though they do not receive cash interest payments until maturity. The tax treatment varies depending on the local tax laws.
Investors are attracted to zero-coupon bonds for their potential for capital appreciation and the ability to lock in a fixed return if held until maturity. However, they are also exposed to interest rate risk – if interest rates rise, the market value of existing zero-coupon bonds may fall, and vice versa. Zero-coupon bonds are often used for specific financial goals, such as funding a future liability or saving for a particular expense, due to their predictable future value.