Are zero-coupon bonds sold at a large premium?
A zero-coupon bond is a type of bond that does not pay any interest to the investor. Instead, it is sold at a lower price than its face value, and the investor receives the face value when the bond matures.
A zero coupon bond is never issued on premium because there would be no return for the investor if the bond is issued at premium. The return for the investor of a zero-coupon bond is the discount on which it is issued.
Zero-coupon bonds (“zeros”) represent a type of bond that does not pay interest during the life of the bond. Instead, investors buy these bonds at a steep discount from the “face value” (the amount a bond will be worth when it matures).
The target purchase price of a zero coupon bond, assuming a desired yield, can be calculated using the present value (PV) formula: price = M / (1 + i)^n. M is the face value at maturity, i is the desired yield divided by 2, and n is the number of years remaining until maturity times 2.
Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities.
A zero-coupon bond is a debt security instrument that does not pay interest. Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity.
A zero coupon bond generally has a reduced market price relative to its par value because the purchaser must maintain ownership of the bond until maturity to turn a profit. A bond that sells for less than its par value is said to sell at a discount.
While you'll be able to buy zeros at deep discounts to face value, you won't receive anything in return for your investment until the term of the bond ends. Along the way, you'll be subject to higher levels of interest rate risk (if interest rates rise) and inflation risk (if prices rise generally in the economy).
When a bond's value exceeds its face value, it sells at a premium. Conversely, the bond sells at a discount when the market value is less than the par value. For example, a bond with a par value of $1,000 is selling at a premium when it can be bought for more than $1,000.
Zeros are also preferred during a period of relatively high interest rates, as the compounding effect is greater. As a zero-coupon bond is issued at a discount to its face value, and then repaid at par, there is a significant liability for the borrower on maturity.
Why would anyone buy a zero-coupon bond?
Purchasing zero-coupon bonds that mature at that time can be a convenient way to help cover the expense. Zero-coupon bonds are also appealing to investors who wish to pass wealth on to their heirs but are concerned about income taxes or gift taxes.
The Difference for Investors
A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. With a normal yield curve, long-term bonds have higher yields than short-term bonds.
A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated short-term price movements.
Zero-coupon bonds are often perceived as long-term investments, although one of the most common examples is a “T-Bill,” a short-term investment. U.S. Treasury Bills (or T-Bills) are short-term zero-coupon bonds (< 1 year) issued by the U.S. government.
Taxation of Capital Gains: The capital gain or loss on the sale of zero coupon bonds is also subject to taxation. If the bond is held to maturity, the capital gain or loss will be equal to the difference between the purchase price and the face value.
Bonds trade at a premium when the coupon or interest rate offered is higher than the interest rate that's being offered for new bonds. A simple way to tell whether a bond is trading at a premium is to check its price. If what you have to pay to purchase a bond is above its face value then it's a premium bond.
If a zero-coupon bond is held for 12 months or more, it is treated as a long-term capital asset. Proceeds on maturity less cost of acquiring the bonds will then be taxed as long-term capital gain.
Treasury Bills or T-bills are also known as Zero-Coupon Bonds, which are short-term government securities or instruments issued by Reserve Bank of India (RBI) on behalf of the Government of India that pays no interest.
T-bills are zero-coupon bonds usually sold at a discount, and the difference between the purchase price and the par amount is your accrued interest.
Premium bonds pay a greater proportion of their cash flows prior to maturity because interest payments are higher. Consequently, their prices tend to be more stable than those of discounted or par bonds.
Can a bond be redeemed at a premium?
Most bonds are redeemable at par (i.e. redeemed at their face value). Some bonds are callable and can be redeemed prior to the maturity date. These types of bonds are redeemable at premium (i.e. value greater than the face value of the bond). The redemption value is stated as a percentage of face value.
If the Bond is Callable, the Equation Changes
Issuers are more likely to call a bond when rates fall since they don't want to keep paying above-market rates. So premium bonds are those most likely to be called.
If interest rates rise the bond will lose value on the open market. But as the bond approaches maturity the market value of the bond will rise. On the day the bond reaches maturity it will be redeemed for face value. So in that sense you can not lose money.
Without accounting for any interest payments, zero-coupon bonds always demonstrate yields to maturity equal to their normal rates of return. The yield to maturity for zero-coupon bonds is also known as the spot rate.
With a zero, instead of getting interest payments, you buy the bond at a discount from the face value of the bond and are paid the face amount when the bond matures.
