Zero-Coupon Bond: A Zero-coupon bond is a bond that is sold at a price far below its face value, makes no annual or semi-annual interest payments, and is redeemed for its face value at maturity. It is issued at a discount to its face value, and it doesn’t make periodic interest payments like traditional bonds. Instead, the investor purchases the bond at a discounted price and receives the full face value of the bond when it matures. The difference between the purchase price and the face value represents the investor’s return on the investment.
Here are some key characteristics of zero-coupon bonds:
- Discounted Purchase Price: Zero-coupon bonds are typically sold at a substantial discount to their face value. The purchase price is significantly lower than what the bond will be worth at maturity.
- No Periodic Interest Payments: Unlike regular bonds that pay periodic interest (known as coupon payments), zero-coupon bonds do not make any interest payments during their term. Instead, the interest is effectively “reinvested” in the bond, leading to its appreciation in value over time.
- Maturity Value: The face value of the bond, also known as the maturity value or par value, is the amount that the bondholder will receive when the bond matures.
- Yield to Maturity (YTM): The yield to maturity is the annualized rate of return that an investor would earn if they held the bond until maturity. It takes into account the purchase price, the face value, and the time until maturity.
- Tax Considerations: Even though zero-coupon bonds do not provide periodic interest payments, investors might still owe taxes on the imputed interest that accrues annually. This is based on the annual increase in the bond’s value, even though it’s not received until maturity.
- Price Volatility: The price of zero-coupon bonds can be more volatile than that of traditional bonds because they are more sensitive to changes in interest rates. As interest rates change, the value of the bond can fluctuate significantly.
- Uses: Zero-coupon bonds are often used for long-term financial goals, such as funding education expenses or retirement. They can provide a known future sum of money if held to maturity, which can help with planning.
It’s important to understand that while zero-coupon bonds offer the potential for a fixed return at maturity, they do not provide any cash flow before that time. Investors should carefully consider their investment objectives, risk tolerance, and the potential tax implications before investing in them. Additionally, they should be aware of the potential risks associated with changes in interest rates and market conditions, which can impact the value of the bonds before maturity. Watch finStream personal finance videos to learn more about Zero-Coupon Bonds.