Zero Coupon Bonds

Introduction

A bond is a long term debt obligation. It is sold by the borrower who is called the "issuer" in order to borrow money for the medium and long term. Typically a bond will have a maturity of between 2 and 20 years. The issuer can be a bank, company or government institution. Zero coupon bonds are unusual. They pay the investor no regular interest and although they represent a small proportion of the bond market zero coupon bonds can have advantages for both the issuer and investor.

The cash flows on a zero coupon bond

A zero coupon bond pays the investor a sum of money (principal) on the maturity or redemption date but no interim coupon (interest payments):

This means that because the investor receives no interest the bond is discounted. Instead of it being issued at or around par value (100% principal) it is issued at a price substantially lower than par. The issue price is determined by the maturity of the bond and the return that the investor requires.

Here is an example of a five year zero coupon bond. The principal of $10,000,000 has been discounted at a rate of 5%. The discounted value is $7,835,262 or 78.35% of par value:

If the bond had a longer maturity and the same interest rate of 5% was used to discount the cash flows its price would be lower. The following example is based on 10 years:

This bond has a discounted value of $6,139,133 or 61.39% of par value and if a higher rate was used the discounted value would be even lower.

Why would an investor want to buy this bond?

One of the main reasons for investors buying zero coupon bonds is that they know exactly what payment they can expect on the maturity date. In the above examples both bonds pay the investor $10m on maturity. For investors that have known future liabilities this is very helpful.

Suppose an investor had a commitment to pay $10m in 5 years time. By purchasing the 5 year zero coupon bond for $7,835,262 the liability is exactly matched and there is no interest rate risk. Had the investor bought a coupon paying bond there would be much more uncertainty.  The investor would be partially dependent on the reinvestment rates achieved on the coupons received in order to accumulate sufficient capital by the maturity date.  For investors that have long dated liabilities (like pension funds) this reinvestment risk is significant.

Investors who buy zero coupon bonds to match their future liabilities are said to be immunizing their portfolio.

Why would an issuer sell a zero coupon bond?

Issuers sell bonds in order to borrow money and a zero coupon bond is just another type of bond that can be issued. For some issuers the deferment of interest payments until the maturity date may be a helpful but often the issuer "swaps" the zero coupon bond in order to obtain a fixed or floating rate cost of money.

One way this can be achieved is as follows. Using the five year zero coupon bond (above) as an example the issuer receives $7,835,262 on the date the bond is issued. The issuer also enters into an interest rate swap either to pay fixed or floating rate interest on a regular basis for the next five years. The principal amount of the swap is also $7,835,262.

In five years time the zero coupon bond and swap both mature. The investor receives $10,000,000 from the issuer.

$2,164,738 of this comes from the swap counterparty that makes one fixed payment to the issuer representing the value of all the interest payments received during the previous five year period.

This means the issuer has borrowed $7,835,262 and the cost of servicing that debt is the interest rate paid on the swap.

What risks do investors face?

Investors in zero coupon bonds face two main risks.

1. Interest rate risk. Zero coupon bonds are price sensitive to changes in interest rates. Long dated zero coupon bonds in particular are very sensitive to movements in interest rates. This means the market value of the zero coupon bond can deteriorate substantially if interest rates increase. (Investors who use zero coupon bonds to immunize their risk may be less concerned because they have a corresponding liability and this should change in value by an equal and opposite amount).

2. Credit risk. Zero coupon bond holders rely on timely repayment from the issuer. Because the investor receives no interest until the redemption date the credit exposure steadily increases. Investors should therefore be mindful of the credit risk being run.

First Published By Barbican Consulting Limited 2010