A Zero-Coupon Bond: What Is It?
An accrual bond, often called a zero-coupon bond, is a financial instrument that does not bear interest but trades at a significant discount, resulting in a profit when the bond matures and is redeemed for its total face value.1 Securities and Exchange Commission of the United States, “Zero Coupon Bond.”
Knowledge of Zero-Coupon Bonds
Certain bonds are issued with no coupons from the beginning, while other bonds become zero-coupon instruments when a financial institution removes the coupons and repackages them. Zero-coupon bonds are more prone to market fluctuations than coupon bonds since they give the whole payment at maturity.
A business or governmental entity may raise funds by issuing bonds. Investors buy bonds when given, lending money to the company issuing the bonds. Throughout the bond’s existence, coupon payments—either semiannually or annually—provide investors with a return.
The bondholder receives repayment equivalent to the bond’s face value when the bond matures. A corporate bond’s face value, or par, is usually expressed as $1,000. A corporate bond offered to investors at a discount may be bought for less than its par value. An investor will earn $1,000, for instance, if they purchase a bond for $920 at a discount. The investor’s profits or return for owning the bond is the $80 return plus any coupon payments received.
Bonds do not, however, always pay coupons. Zero-coupon bonds are those that don’t have any. These bonds have a steep discount when first issued and mature at par value. The investor’s return is calculated as the difference between the purchase price and the par value. The investor receives payment in the amount of the capital invested plus interest at a set rate, compounded semiannually.
A zero-coupon bond’s interest is imputed interest, which means that rather than being an established interest rate, it is an estimate of the bond’s interest rate. For instance, one may pay around $6,855 for a $20,000 face-value bond with a 5.5% return in 20 years. The investor will get $20,000 after 20 years. The difference between $20,000 and $6,855 (or $13,145) represents the interest that accrues automatically until the bond matures. One term used to describe imputed interest is “phantom interest.”
The Internal Revenue Service (IRS) states that income tax is due on the imputed interest on the bond.22 Therefore, investors may still be required to pay federal, state, and local income taxes on the annual imputed interest, even if zero-coupon bonds only pay coupons at maturity. One approach to avoiding paying income taxes on these securities is to purchase a tax-exempt corporate zero-coupon bond, buy zero-coupon bonds in a tax-exempt account, or buy municipal zero-coupon bonds.
Setting a Zero-Coupon Bond Price
A zero-coupon bond’s price may be computed as follows:
Price = M ÷ (1 + r)n
- M = Maturity value or face value of the bond
- r = required rate of interest
- n = number of years until maturity
An investor will be ready to pay the following if they want to earn 6% on a bond that has a par value of $25,000 and is scheduled to maturity in three years:
$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 minus $25,000, or 84% of its face value. The investor receives $25,000 at maturity, less $20,991 ($4,009 = 6% annual interest).
The less the bond costs the investor, the longer it takes to mature, and vice versa. Zero-coupon bonds often have extended maturities, with initial maturities of ten years or more. Thanks to these long-term maturity dates, investors can plan for long-term objectives, including investing in a child’s college education. An investor might contribute a tiny quantity of money that can increase over time thanks to the bond’s steep discount.
Numerous institutions, such as companies, state and local governments, and the U.S. Treasury, can issue zero-coupon bonds. The majority of zero-coupon bonds are traded on the main markets.
Like other bonds, zero-coupon bonds are exposed to interest rate risk if investors sell them before they mature, which carries various risks.
What Distinctions Exist Between Regular and Zero-Coupon Bonds?
The main distinction between a bond with no coupons and one with regular interest payments is the amount paid. Ordinary bonds, commonly known as coupon bonds, have principal repayments at maturity and interest payments during the bond’s term. When an investor redeems a zero-coupon bond for its total face value at maturity, they will have made money even though the bond does not pay interest and trades at a significant discount.
What Is the Price of a Zero-Coupon Bond by an Investor?
The imputed interest rate that an investor may receive at maturity is one of the primary factors influencing their decision to buy a zero-coupon bond. The following formula may be used to get the price of a zero-coupon bond:
Maturity value ÷ (1 + necessary interest rate) number of years to maturity is the price of a zero-coupon bond.
How does the IRS tax zero-coupon bonds?
Sometimes called “phantom interest,” imputation interest is an approximated interest rate. Income tax is payable on the bond’s imputed interest. The IRS has relevant federal rates that provide a minimum interest rate concerning imputed interest and original issue discount regulations. The IRS employs an accretive technique for calculating the imputed interest on Treasury bonds.
Conclusion
- An interest-free debt security instrument is a zero-coupon bond.
- Zero-coupon bonds give total face value (par) gains at maturity and trade at steep discounts.
- An investor’s return is the difference between a zero-coupon bond’s par value and its acquisition price.
