What are zero coupon bonds and how do they work?

Zero coupon bonds are one of the purest forms of bond investment. Unlike traditional bonds, these financial instruments do not provide for the payment of periodic coupons, offering instead a single yield at maturity.

Here is the detailed description of how zero coupon bonds work, starting from their basic structure and arriving at the different types available on the market. We will examine the calculation of the yield, the risk profiles and the most effective investment strategies, without forgetting the tax aspects.

What are zero coupon bonds

In the world of investments, we often come across financial instruments that are distinguished by their particular structure. One of these is certainly represented by zero coupon bonds.

Zero coupon bonds are debt securities that are issued at a discount, or at a lower price than their nominal value. The main characteristic of these instruments is the absence of periodic interest payments during the life of the security. The yield is achieved through the difference between the purchase price and the repayment value at maturity.

What distinguishes these securities from traditional bonds is the absence of coupons, or periodic interest payments. While traditional bonds distribute interest at regular intervals, zero coupon bonds concentrate all the yield at the time of repayment.

Let’s take a practical example: we can find a zero coupon bond at a cost of 970 euros, for a capital to be repaid at maturity of 1,000 euros. In this case, the gain of 30 euros represents the overall return on the investment.

The main advantages that we find, therefore, include:

• certainty of return if held to maturity;
• elimination of the problem of reinvesting periodic interest;
• possibility of accurately planning the final capital.

However, we must also consider some significant disadvantages. Zero coupon bonds are generally more sensitive to changes in interest rates than traditional bonds. Furthermore, the absence of intermediate cash flows can represent a disadvantage for those who need periodic income.

As regards the duration, we note that these instruments are usually issued with short maturities, typically from one to three years, although there are issues with longer durations for specific investment needs.

How Zero Coupon Bonds Work and Calculating Yield

To understand how zero coupon bonds work, we can start with an example calculation. In fact, the evaluation of this investment instrument also passes through the explanation of how to calculate the yield of zero coupon bonds.

To calculate the yield of a zero coupon bond, we use the Internal Rate of Return (IRR), also known as the Yield to Maturity (TRES). The basic formula is:

• r = (VN/P)^(1/t) - 1

Where:

• VN = Nominal Value
• P = Purchase Price
• t = Time to Maturity in years

In the case of zero coupon bonds, we note a particular characteristic: the duration coincides exactly with the residual life of the security. This makes them particularly sensitive to changes in interest rates.

For long-term zero-coupon bonds, this sensitivity translates into higher volatility than traditional bonds. It is important to consider this aspect when evaluating the investment.

Practical calculation examples
Let’s take a concrete example: consider a zero-coupon bond with par value of 100 euros, maturity in 3 years and purchase price of 92 euros. Applying the IRR formula:

• r = (100/92)^(1/3) - 1 = 2.82%

This means that the investment offers an annual return of 2.82%. It should be noted that this return will be achieved only by holding the bond until maturity.

The sensitivity to the interest rate is clearly evident: a 1% change in the rate of return can cause a significant change in the price of the bond, especially for those with longer maturities.

Types of zero coupon bonds on the market

For example, on the Italian market we find different types of zero coupon bonds, each with specific characteristics that make it suitable for different investment strategies.

Government bonds (BOT and CTZ)
Government bonds represent the most widespread category of zero coupon bonds in Italy. Ordinary Treasury Bonds (BOT) are issued with the following maturities:

• 3 months
• 6 months
• 12 months

Flexible BOTs with variable duration within the year
Zero Coupon Treasury Certificates (CTZ) have a duration of 24 months and are placed through monthly auctions. The minimum subscription for CTZs is 1,000 euros or multiples, with placement commissions of 0.15%.

Corporate zero coupon bonds
In the private sector, corporate zero coupon bonds are distinguished by their simple structure compared to other types of corporate bonds. These securities are sold at a discount to their nominal value and offer returns that vary based on the creditworthiness of the issuer.

Supranational issues
Supranational issues, such as those of the European Investment Bank (EIB), represent a particular category of zero coupon bonds. These securities are typically issued with longer maturities, which can reach up to 10 or 30 years. Their distinguishing feature is the high credit standing of the issuer, which makes them particularly interesting for institutional investors and for those seeking long-term investments with a low risk profile.

Zero Coupon Bonds: risk and investment

Investing in zero coupon bonds requires a thorough understanding of the risks and opportunities that these instruments offer. When evaluating zero coupon bonds, we must consider some fundamental risks.

• Interest rate risk: these securities are particularly sensitive to changes in interest rates. When rates increase, the value of existing bonds tends to decrease significantly.
• Inflation risk: the absence of periodic payments can expose the investment to the erosion of purchasing power over time.
• Liquidity risk: zero coupon bonds are generally less liquid than traditional bonds.

To effectively manage these risks, it is necessary to implement different diversification strategies. First of all, it is essential to distribute investments among several issuers to reduce the risk of default. Furthermore, it is essential to balance the portfolio by including securities with different maturities and different risk-return profiles.

To optimize the risk-return profile, it is necessary to carefully consider the duration based on market conditions. In particular, when we expect a rise in rates, it is advisable to reduce the average duration of the portfolio. On the contrary, in scenarios of falling rates, a longer duration can offer greater opportunities for capital appreciation.

Original article published on Money.it Italy. Original title: Cosa sono le obbligazioni zero coupon e come funzionano