Definition of Zero-Coupon Bond

What is a zero-coupon bond? What is the definition of the term zero-coupon bond?

Before we get into zero coupon bonds, let's outline the characteristics of a traditional bond as it will help us in defining a zero coupon bond.

With a traditional bond, regular interest payments are made and the principal is returned at maturity.

With a zero coupon bond, regular interest payments are NOT made and the principal is returned at maturity.

So wait - how do zero coupon bonds make money then if they don't pay interest?

Simple - a zero coupon bond is sold at below its face value.

So, let's say that you purchase a XYZ zero-coupon at $400 in 1997. The bond will mature in 2012, and at that time XYZ will pay you $1,000.

So, instead of receiving regular interest payments, you will receive $1,000 when the bond matures in 2012, giving you a total gain of $600 ($1,000 - $400).

This is a zero-coupon bond.

The most famous example of a zero-coupon bond? The US T-bill (or Treasury bill).

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