Zero-coupon bonds are a special type of bond that don’t pay interest (called “coupons” in financial lingo), unlike traditional bonds. They’re usually issued at a price below their face value (also known as par value or redemption value) and generate a profit for the investor at maturity through the difference between the purchase price and the amount repaid.
How Zero-Coupon Bonds Work
A zero-coupon bond is issued at a discount to its face value. For example, a bond with a face value of €1,000 might be sold for €950. The investor doesn’t receive any payments during the life of the bond but benefits from the gradual appreciation of the bond’s value until it’s redeemed for €1,000 at the agreed-upon maturity date.
The bond’s return comes solely from the gap between the purchase price and the redemption value. This capital gain represents the investor’s profit.
Interest Rate Sensitivity
Zero-coupon bonds are sensitive to changes in interest rates. When rates rise, the market value of these bonds falls because investors can find better yields elsewhere. Conversely, when rates drop, their value goes up.
Uses of Zero-Coupon Bonds
Zero-coupon bonds are commonly used for short-term financing. For example, Treasury bills are almost always issued in this form. Unlike other types of bonds, these instruments are straightforward to understand, and calculating their yield is particularly simple.
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