What is a Zero-Coupon Convertible?

A zero-coupon convertible is a fixed-income instrument that combines the characteristics of a convertible bond and a zero-coupon bond. The convertible feature allows bondholders to convert bonds into the issuer’s common stock at a specific conversion price. The zero-coupon part indicates that the bond pays no interest and is thus offered at a discount to par value.

An Understanding of Convertibles at Zero Coupon

Zero-coupon convertibles combine the two characteristics of convertibles and zero-coupons. A debt instrument with zero interest payments is known as a zero-coupon security. At the time of maturity, the investor gets the face value of the deposit, which they purchased at a discount. Zero coupons have no risk of reinvestment since no payments are made until the bond matures. A convertible security is a debt instrument that may be converted into shares of the issuing firm at a certain point in time. This is an embedded put option that allows bondholders to convert their bonds into shares. It also motivates investors by allowing them to profit from any increase in the issuer’s stock price.

Hence, a zero-coupon convertible is a bond that pays no interest and may be converted into the issuing company’s equity at a specific price for the shares. When buying this asset, an investor receives a discount for giving up any interest income. However, bondholders retain precedence over equity holders as creditors in the event of bankruptcy. They also stand to gain from the conversion option, allowing them to profit from the share swap.

However, these financial instruments have an inherent feature that limits the investor’s upside potential by enabling the issuer to compel the conversion of the bonds when the stock performs as anticipated. Furthermore, since the value of the convertible option depends on the company’s performance during the debt instrument’s life, zero-coupon convertibles often have a volatile secondary market.

A municipal zero-coupon that can be converted into an interest-paying bond at a certain point before the maturity date is also known as a zero-coupon convertible. When a local government issues these municipal convertibles, they are tax-exempt bonds that may be converted into other bonds with potentially higher yields.

Particular Points to Remember

Regarding the yield investors seek, the zero-coupon and convertible characteristics balance each other. Because zero-coupon bonds don’t have any regular interest payments to offset the risk of owning them, they are often the most volatile fixed-income assets. Investors want a little greater yield to retain them as a consequence. However, since investors can be ready to pay more for the convertible feature, convertibles pay a lower yield than other bonds of the same duration and quality.

To make up for the lack of coupons, the issuer of zero-coupon convertible securities raises the principal amount of the deposit annually. Despite the difference in payment to bondholders, a zero-coupon convertible and an interest-paying convertible with the same maturity and call conditions will have almost the same conversion price.

Zero-Coupon Convertibles at a Price

Zero-coupon convertibles are valued using the dividend valuation model, tree-based models (such as the binomial or trinomial model), or option pricing models like the Black-Scholes model.

The inputs needed to price the security include the actual share price, presumptions about how the price will behave, an assumed equity value, and an assumed volatility level. Due to their complexity, skilled investors exclusively trade zero-coupon convertibles.

Conclusion

• Because of the zero-coupon characteristic, these convertibles are offered at a discount and mature to face value if converted after the maturity date.
• A zero-coupon convertible bond is one that a company issues but doesn’t pay bondholders any ongoing interest on.
• Zero-coupon convertibles benefit investors in bankruptcy, as bondholders get priority repayment over shareholders before they are converted.
• Because of this, these two characteristics often balance each other out in terms of risk and return to investors, even if it might be difficult to price these assets appropriately.