A zero coupon bond or zero bond is a long-term bond which does not pay out interest. Instead, zero coupon bonds are sold at a discount on their face value. When they reach their maturity date, the investor receives the full face value of the bond. The difference between the discounted price paid for the bond and the face value received when the bond matures makes up the yield.
Example: In order to raise capital, a company issues a zero coupon bond with a face value of 100 Swiss francs and a bond term of 5 years. It offers these bonds to investors at a 25% discount, or 75 francs per bond. At the end of the 5-year bond term, investors can cash in their bonds for 100 francs per bond, earning a yield of 25 francs per bond.
Because issuers do not have to pay out regular interest on zero coupon bonds, this type of bond is often used by issuers looking for long-term financing and by investors looking to earn fixed yields on long term investments.
As with other bonds, the longer the bond term, the higher the risk of the issuer becoming insolvent and defaulting on its loans. Zero coupon bonds bear more risk than interest-bearing bonds because investors do not benefit from yields until the end of the bond term.
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