Zero-Coupon Bond

Explained:

accrued-coupon bond

deferred-coupon bond

deferred-interest bond

original issue discount bond

In the fixed income markets, there are a variety of instruments that defer the payment of interest. This article focuses on instruments that have terms greater than a year. See the article discount instruments for the shorter-term forms.

Generally, the instruments are called deferred-interest bonds (DIBs). They fall into three categories.

Accrued-coupon bonds are issued at some par value and have a stated nominal yield. Rather than pay coupons, they accrue them until maturity.

Zero-coupon bonds have a par value that is their maturity value. They are issued at a discount from that par value. These are also called zeros or original issue discount (OID) bonds.

Deferred-coupon bonds (or split-coupon bonds) pay no coupons for their first few years but then pay a higher coupon than they otherwise would for the remainder of their term. Usually, they are issued below par. If the issuer's credit quality doesn't deteriorate and interest rates don't rise, they trade above par by the time they start paying coupons. They mature for their par value plus the final coupon.

The instruments generally have terms of ten years or more. If they are issued with shorter terms, they may be called notes instead of bonds. All three structures are illustrated in Exhibit 1.

Cash Flows of Accrued-Coupon, Zero-Coupon and Deferred-Coupon Bonds
Exhibit 1

Cash flows of an accrued-coupon, zero-coupon and deferred-coupon bond are compared. A par value of USD 100 is assumed for all three bonds.

While accrued-coupon and zero-coupon bonds only pay interest at maturity, for accounting and tax purposes, interest is generally recognized as income when it accrues. Treatment of deferred-coupon bonds depends upon the specific structure and jurisdiction.

Paradoxically, you will hear of accrued-coupon and zero-coupon bonds being described as either safe, conservative investments or risky, speculative investments. It all depends on how you intend to use and account for them. For a buy-and-hold investor who accounts for them at book value, the bonds can be a safe investment, so long as the issuer is of good credit quality. They guarantee a specific yield until maturity. Because they don't pay coupons, they pose no reinvestment risk. On the other hand, for investors who may sell the bonds prior to maturity or account for them at market value, they can be quite risky. Their duration equals their time to maturity. Many of these bonds have terms of 20 or 30 years. With durations like that, their market values can be as volatile as those of common stocks. Examples of these types of bonds are municipal accrued-coupon bonds and Treasury zero-coupon bonds.

Deferred-coupon bonds usually have considerable credit risk. This is because they tend to be issued by corporations that lack the cash flow to meet near-term coupon payments. Usually, they are junk bonds. Two variants of deferred-coupon bonds are

step-up bonds, which pay a low coupon for the first few years and a higher coupon after that, and

payment-in-kind (PIK) bonds, which are like regular coupon bonds but give the issuer the option of paying coupons in cash or in more bonds.

Securitizations are often structured with tranches that defer interest. In the context of collateralized mortgage obligations, these are called Z bonds.

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