In plain words: A debt security that doesn't pay interest but is traded at a deep discount, rendering profit at maturity.
A zero-coupon bond is a kind of debt that pays no periodic interest. Instead of receiving regular coupons, an investor buys it for less than its face value and is repaid the full amount when the bond matures. The return is the gap between the discounted purchase price and the final payout.
How does a zero-coupon bond make money?
The profit comes entirely from the discount. If a bond worth a certain amount at maturity is bought well below that figure, the difference represents the accumulated return. This makes it a distinct member of the bonds family, since there is no income stream along the way.
Why might a zero-coupon bond suit a long horizon?
Because all the value arrives at maturity, these instruments are often described in the context of a known future date and a long timeframe. Their price can be sensitive to interest rate changes before maturity, adding volatility. For the broader mechanics, a closer look at bonds gives helpful context.
Key takeaways
- A zero-coupon bond pays no periodic interest and is sold at a discount.
- Its return is the difference between purchase price and face value at maturity.
- Its price can be sensitive to interest rate changes before it matures.