Zero-coupon bond

Anyone who lends money to a state or a company usually receives a security as a promissory note in return. Normally, the debtor pays interest on it every year and repays the borrowed sum at the end of the term. With a zero-coupon bond, these annual payments are dropped. You pay in less at the start than you get back at the end, and it is precisely this difference that constitutes the earnings. An example: you invest 700 euros today and receive 1,000 euros in ten years. In between, nothing happens — no money comes in, but none is lost either.

One single payday instead of many small ones

The greatest practical advantage is predictability. Anyone who knows they will need a certain sum in exactly twelve years can invest for it today with pinpoint accuracy. Insurance companies and pension funds make use of this because they know their future payouts fairly precisely. They structure a bond so that it matures exactly when the money is needed.

With regular bonds, on the other hand, a problem arises that experts call reinvestment risk. You receive interest paid out every year and have to reinvest that money. Nobody knows whether interest rates will still be at the same level then. With a zero-coupon bond, this question never arises, because nothing is paid out along the way.

In return, the price of such securities fluctuates more sharply than that of other bonds. Because all the money only flows at the very end, a change in market interest rates has a particularly strong effect on today’s value. If interest rates rise, the price of a long-dated zero-coupon bond falls significantly. Anyone who holds it to the end notices nothing of this. Anyone who has to sell beforehand can incur real losses.

How the issue price is calculated

The price is derived from the repayment amount, the term, and the market interest rate. In effect, you calculate backwards: what sum would you need to invest today so that, with interest and compound interest, it amounts to exactly the promised amount at the end? At three percent interest and a ten-year term, that comes to around 744 euros today for a repayment of 1,000 euros. Experts call this backward calculation discounting.

From this follows a simple rule: the longer the term and the higher the market interest rate, the lower the issue price. Very long-dated zero-coupon bonds are therefore sometimes sold for a fraction of their face value. The value then slowly grows over the years toward the repayment amount.

A common misconception is that a zero-coupon bond is interest-free. That is not true. The interest is there, it just isn’t paid out but is factored into the low purchase price right from the start. The tax authorities see it the same way and tax the profit — though in Germany, as a rule, only upon repayment or sale.

Where zero-coupon bonds show up in the market

In the news, the term is usually encountered under its English name, zero-coupon bond, or simply zero bond. States issue such securities, especially for short terms: German Bubills with a twelve-month term and American Treasury Bills work exactly on this principle. In addition, banks break down regular bonds into their individual payments and sell each of them separately. Such building blocks are called strips and are likewise zero-coupon bonds.

For private investors, they are more of a niche topic, but they do turn up in funds and in retirement planning. They are also of interest to people betting on falling interest rates. Because their price reacts so strongly, long-dated zero-coupon bonds rise particularly sharply when interest rates fall — which conversely also makes them risky.

A final point concerns safety. Over the entire term, not a single cent comes back. If the debtor goes bankrupt, the entire investment is at risk. With a normal bond, you would at least already have pocketed some interest payments. That is why it is especially worthwhile to take a close look at who is issuing the paper.