Zero-coupon bond
A bond that pays no interim interest. It is sold below par and redeemed at par, and the whole of the return is the pull towards par over its life.
Example
A five-year zero yielding 4% costs 1,000 / 1.04^5 = 821.93 and pays 1,000 at maturity, an annualised 4.0000% if the issuer pays.
Important
It removes reinvestment risk, because there is nothing to reinvest - and it is the most rate-sensitive bond of its maturity, since its duration equals its maturity exactly. Removing one risk did not remove risk.
Related terms
- Reinvestment risk — The risk that coupons, or the proceeds of a maturing bond, must be put back to work at a lower rate than the one they came from - which is what makes a quoted yield to maturity conditional rather than certain.
- Duration — The present-value-weighted average time until a bond's cash flows are received (Macaulay duration), and by extension the measure of how much its price moves when yields change. Modified duration is Macaulay duration divided by one plus the yield.
- Par value — The sum the issuer repays at maturity, per unit of the bond. Also called face value or principal. It is the base on which the coupon percentage is calculated.
- Duration matching — Choosing fixed income holdings whose timing corresponds to a known future obligation, so the money arrives when it is needed.
Lessons that explain it
All 578 terms in the Investing glossary