What is a Zero Coupon Bond?
A zero-coupon bond (accrual bond, deep discount bond or discount bond) is a debt security which pays no interest or coupon (annual dividend). The holder receives income annually or semi-annually from coupon payments.
Most of the zero-coupon bonds pay a face value, a set amount of money; but some can be inflation indexed, therefore guaranteeing a set amount of purchasing power to its holder. Due to the characteristics of these bonds, such as being tax efficient (gains are usually taxed at a rate of 18%), this sort of bond is issued by split-capital investment trusts.
Why are zero coupon bonds more volatile?
The price fluctuations are more volatile for zero-coupon bonds than for regular coupon bonds, in part because they offer the entire payment at maturity. However, zero-coupon bonds are seen as a long-term investment due to the bonds’ deep discount, which allows investors to grow their capital steadily over a prolonged period of time.
For example, pension funds and insurance companies tend to work with long maturity zero-coupon bonds because of the bonds’ long duration. This long duration implies that their prices are sensitive to changes in the interest rate, and therefore offset or immunise the interest rate risk of these firms’ long-term liabilities.
Some of the most popular zero-coupon bonds are issued by the US Treasury, national and local governments, and also corporations.
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Category: Financial Glossary