One of the niche offerings in the debt securities market is the zero coupon bond. It's possible to find these investments issued by the U.S. Department of the Treasury, corporations, as well as municipalities.
In this article, we're going to discuss the topic of zero coupon bonds. We'll start that discussion with a definition of the term, as well as an example that demonstrates the concept behind these investments. Next, we'll talk about the features of these securities, and why they are valued by investors. Finally, we'll talk about some variations of these offerings, as well as the risk of nonpayment to bondholders.
Zero Coupon Bonds
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By definition, a zero coupon does not provide the investor with periodic interest payments. Instead, these securities are sold at a discount to their face value, and the investor is entitled to the full face value of the bond when it matures. This is why these securities are sometimes referred to as discount bonds.
The U.S. government issues these securities in the form of Treasury Bills and Savings Bonds. It's also possible for large corporations to offer these types of securities to the public. When most investors talk about zero coupon bonds, they are referring to securities issued by municipalities. The remainder of this article will focus on the features and risks associated with those investments.
The best way to illustrate how a zero coupon bond is valued, and therefore purchased, is through an example.
Zero Coupon Bond: Example
In this example, the investor purchased a $1,000 bond, maturing in 10 years, with a coupon rate of 5.0% (compounded semi-annually). When issued, this bond would sell for $610.27. Over time, the value of this bond will grow as demonstrated in the table below:
| Year | Value | Year | Value |
| 1 | $641.17 | 6 | $820.75 |
| 2 | $673.62 | 7 | $862.30 |
| 3 | $707.73 | 8 | $905.95 |
| 4 | $743.56 | 9 | $951.81 |
| 5 | $781.20 | 10 | $1,000.00 |
The above table is read like this:
Everything else being equal (more on that later), the fair price to pay for this security would be $707.73 three years after it is issued. After six years, the bond's value would have risen to $820.75.
Features
One of the reasons investors are interested in zero coupon bonds offered by municipalities is their favorable tax treatment. Under the current tax law, the interest income received from these securities is exempt from federal income taxes. It's often exempt from state, as well as local income taxes too.
Income Taxes
A zero coupon bond that is free from federal income taxes provides investors in higher tax brackets with an even greater advantage relative to taxable securities. For the same reason, these securities would not be an obvious choice to hold as part of a tax-free account such as a Roth IRA.
This tax-free benefit only applies to the interest income portion of these bonds. Since zero coupon bonds will carry a fixed rate of interest when issued, if interest rates were to fall, the value of the bond would increase. If the bondholder were to sell the security before it matures, a portion of the selling price might qualify as a capital gain. This can be a common occurrence in times of falling interest rates. The same logic would apply to a capital loss when interest rates rise.
Low Initial Investment
Zero coupon bonds are sold with maturities of up to 40 years. Therefore, these securities are often sold at a deep discount. Typically, bonds are sold in denominations of $5,000; but as the above example demonstrates, even a security maturing in ten years will be sold at a substantial discount from its face value. This allows the investor to participate in this market with a relatively low initial investment.
Reinvestment Risk
When an investor purchases a bond that pays periodic interest, and the interest payment received is not needed to pay for an immediate expense, they must decide where to reinvest these payments. As such, these bonds create a reinvestment risk for the holder.
Zero coupon bonds allow the investor to lock in a fixed rate of interest for a predetermined period of time.
Call Provisions
Bonds are sometimes subject to call provisions, and this feature can also apply to zero coupon bonds. A call provision allows the issuer to redeem a security before its maturity date. Since the call provision carries with it a redemption risk, the holders of these securities are usually paid a premium if called in by the issuer.
Inflation Indexing
While most zero coupon bonds are sold with a fixed rate of interest, some are sold with an inflation index feature. Securities with an inflation index provide the holders with a hedge against inflation. Instead of promising to pay the face value of the security, the maturity value will represent the cumulative impact of an inflation index.
Risks
As is the case with all debt, zero coupon bonds carry the risk of non-payment. In terms of quality, zeros are only second to Treasury securities. Credit rating agencies typically assign credit quality ratings of A or higher to zero coupon bonds. While investors should always understand the risks associated with a purchase, the risk of default on these securities is typically very low.
Interest Rate Risk
When a bond carries a fixed rate of interest, the market value of the security will fluctuate with interest rates. If interest rates increase, newer issues will offer higher rates to investors. When that happens, the value of securities carrying a lower rate of interest will decline. This rule of thumb can be stated as:
The value of a bond will move inversely to interest rates. In addition, the longer the time until a bond matures, the greater the price movement of the bond.
If an investor is forced to sell a zero coupon bond during times of rising interest rates, they run the risk of a capital loss on the security.
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