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Glossary
What is a zero-coupon bond?
Definition of a zero-coupon bond
A zero-coupon bond is a debt instrument that does not pay periodic interest. Instead, it is issued at a discount to its face value and redeemed at maturity for its full-face value, with the difference representing the investor’s return.
Explanation of zero-coupon bond
A zero-coupon bond is a type of fixed-income security where no interest payments or coupons are made during its term. Rather than receiving regular interest, the investor purchases the bond at a price below its nominal value and receives the full-face value at maturity.
The return arises from the gradual increase in the bond’s value over time as it approaches its redemption amount, this increase reflects the implicit interest earned.
Zero-coupon bonds are issued by governments and corporate entities and may be used for long-term funding. In financial reporting, such instruments are generally measured using amortised cost under UK IFRS or FRS 102, with interest income recognised over time using the effective interest method. They are commonly used in investment planning, structured finance and certain pension funding arrangements.
Key characteristics of zero-coupon bond
Key characteristics of zero-coupon bonds include the following:
- It pays no periodic interest during its term.
- It is issued at a discount to its face value.
- It is redeemed at par value on maturity.
- Its return is derived from the difference between purchase price and redemption value.
- It is sensitive to changes in interest rates due to the absence of interim cash flows.
How zero-coupon bonds works
A zero-coupon bond typically operates as follows:
- The bond is issued at a price below its face value.
- The investor pays the discounted price upfront.
- No interest payments are made during the bond’s term.
- The bond increases in value over time as interest accrues implicitly.
- At maturity, the issuer repays the full-face value to the investor.
The difference between the issue price and the redemption amount represents the total return over the life of the bond.
Example of zero-coupon bonds in practice
A UK company issues a five-year zero-coupon bond with a face value of £1000 at an issue price of £800. The investor pays £800 at the outset and receives £1000 at maturity. The £200 difference represents the total interest earned over five years, recognised over time for accounting purposes.
Related terms
- Bond
- Face value
- Discount rate
- Effective interest rate
- Amortised cost
- Fixed-income security
- Yield to maturity
Common misconceptions about zero-coupon bond
Many believe that zero-coupon bonds do not give a return; but in reality, they yield a return through appreciation (the difference between the purchase price and the amount received at maturity).
It’s commonly assumed that zero-coupon bonds avoid interest. However, the interest is built into the discounted issue price.
Many believe zero-coupon bonds to be risk free, but this is not the case unless issued by a government with minimal credit risk.
Frequently asked questions about zero-coupon bonds
Why would an investor choose a zero-coupon bond?
A zero-coupon bond may be used to secure a known amount at a future date, as the redemption value is fixed. It can also simplify cash flow planning because there are no interim interest payments.
How is income recognised for accounting purposes?
Interest income is generally recognised over the life of the bond using the effective interest method under UK IFRS and FRS 102, even though no cash interest is received during the term.
Are zero-coupon bonds more sensitive to interest rate changes?
Yes. Because all cash is received at maturity, their price tends to be more sensitive to changes in market interest rates compared with bonds that pay regular coupons.
Are zero-coupon bonds taxed in the UK?
Tax treatment depends on the nature of the issuer and the holder. In many cases, the accrued return may be subject to UK tax even though no cash interest is received during the term.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this glossary entry only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.
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