2.9.2 Zero Coupon Bonds
A zero coupon bond (or “zero”) is a bond that does not make periodic interest payments. Instead, a zero coupon bond is issued at a deep discount to its face value, and the bondholder receives the face (or par) value at maturity; a zero thus is a type of discount bond.
For example, a 20-year bond that has a par value of $5,000 may have a $1,000 issue price. A lower price means a greater return on overall investment.
Zeros are attractive to the issuer (borrower) because they do not cost anything in terms of interest payments until the bond matures. They are attractive to the lender (investor) because they offer greater leverage. Instead of loaning $5,000 for $5,000 worth of bonds, in our example above, the investor needs to offer up only $1,000, freeing the balance for other investments. However, even though zeros do not make interest payments, the IRS treats the discount as interest, and the bondholder will need to pay taxes on this “phantom interest” at his ordinary income rate. In our example above, the taxpayer has to calculate the discount and divide by the number of years to find the annual interest payment (($5,000 – $1,000) / 20 years = $200 per year).
Another advantage for the bondholder is that zero coupon bonds lock in the current interest rate for the life of the bond, eliminating reinvestment risk. If the investor had bought an interest-paying bond, the periodic coupon payments would need to be reinvested, possibly at lower interest rates than the coupon rate. With zeros, the coupon is effectively paid at maturity, meaning that it is always earning the prevailing interest rate at the time the bond was issued.
Deferred coupon payments also mean that zero coupon bonds offer the disadvantage of having a higher credit risk, since the entire investment is at risk until maturity. Credit risk is further enhanced by the fact that compani