Zero bonds or zero coupon bonds meaning: what is it?
In this article, we discuss the meaning of a zerobond or zero-coupon bond.
What is a zerobond or zero-coupon bond?
A zerobond (zero-coupon bond) is a bond that does not pay interest. Zerobonds are sold at a discount, and you earn your return at the end of the term when you receive the face value.
In technical terms, a zerobond can be described as:
- A bond issued below par (lower than the price on the bond)
- On the redemption date, the bond is paid out at the face value (the price on the bond).
How do standard bonds work?
Every bond is an investment product through which a company or government entity can raise capital. This capital is provided as a loan: unlike with stocks, bond investors do not become co-owners.
Bond investors typically receive interest payments. These payments are made semi-annually or annually to the investor during the term of the bond. At the end of the bond’s term, the bondholder is repaid an amount equal to the face value of the bond.
If you want to learn more about investing in bonds, then read our special on investing in bonds:
The return on zerobonds
Not all bonds work with the interest payments described above. This applies, for example, to zero-coupon bonds or zerobonds. These bonds are issued at a large discount and repay the face value on the maturity date.
The difference between the purchase price and the face value constitutes the investor’s ultimate return. Indirectly, as an investor, you still receive a kind of interest.
At the end of the term, the investor receives the principal plus the promised additional amount. You can calculate the annual return by dividing the total return by the number of years the bond runs. This interest is also called imputed or phantom interest.
In some cases, the payout at the end of the term rises with inflation.
It is also possible to sell the zerobond before the end of the term. The price of a zerobond can fluctuate strongly under the influence of market interest rates and inflation. When you sell at the right time, you can make a capital gain.
Good explanation of how zerobonds work
Example of a zerobond investment
Let us explain the principle of a zerobond with a simple example. You buy a bond for $100 with a maturity of ten years. After ten years, you receive $200 back.
In this case, your return is $10 or 10% per year.
Which companies issue these zerobonds?
The companies that issue zerobonds are usually companies that want to use the money to grow quickly. Often these are tech companies or special departments of a government agency.
Because they do not pay fixed interest during the months, they can use more money to grow or work on projects. You will then receive your payment in the form of phantom interest or by selling your bonds at the real price on the maturity date.
