Zero Coupon Bonds
Zero coupon bonds are bonds that pays no interest. The coupon on a bond is simply the amount of interest that a particular bond will pay
the bondholder.
Why would anyone want to buy a bond that pays no interest? Well, zero coupon bonds are sold at a steep discount –
a rate much lower than the face value of the bond. So when the bondholder redeems the bond at maturity they will
receive the face value which is more than what they originally paid for it. In other words, it's an
automatic profit for the bondholder.
Here's an example (and we'll keep the numbers simple):
Let's say a bond has a face value (par value) of $1,000 and matures in one year. Since this is
a zero coupon, meaning it pays no interest, no one in their right mind would pay the full $1,000 for it. So instead,
someone buys it for $900. For the entire year, the bondholder will receive no interest on this investment. However,
when the year is up the bondholder gets to redeem the bond for the full face value, which is $1,000. Since they only
paid $900 for it, they have an automatic profit of $100. This equates to a 10% return on their investment.
Now you can see the value of zero coupon bonds.
