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Information > Financial Terms > This page Zero-Coupon Bonds and Zero-Coupon
Convertible ZERO-COUPON
BONDS
Corporate
bonds that do not pay interest periodically (semi-annually) in the fashion
of conventional types of bonds, but instead sell at discounts of par until
their final maturity, when payment of principal at par plus all of the
interest accumulated (compounded) at the rate specified at the time of
original issuance of the bonds is paid in a lump sum. This
innovation in bond financing first appeared in 1981, at a time of high
prevailing interest rates, and has proved to be popular under such conditions
with both corporate issuers and investors.
For issuing corporations, the advantages are that no cash is actually
paid out until final maturity, but in the meantime the tax deductible
amortization of the discount provides savings each year on income taxes.
(As of 1982, the question was still unresolved as to whether the
discount in full could be amortized on a straight-line basis per year
or, as the Treasury maintained, the tax deduction should be based on the
effective annual cost to the corporation times the discount dollar amount
of principal as originally paid at issuance by the investor and accreting
each year to maturity - a method which would result in lower annual amortization
for the corporation than the straight-line method.) For
investors, the attraction of zero-coupon bonds is the locking in of the
prevailing high interest rate at issuance of the bonds, to accumulate
compounded and to be paid at final maturity along with the full principal
at par. Thus a combination
of high interest income (based on the specified interest rate at issuance)
and the capital gain from discount price at issuance to full par at maturity
would be indicated. Such has
been the attraction of zero-coupon bonds that issuing corporations have
been able to achieve a savings in the interest rate on such issues, fractional
though it may be, as compared with prevailing market yields on conventional
bonds of the same quality. For
investors, zero-coupon bonds are especially suitable for tax-deferred
plans, such as individual retirement accounts (IRAs), Keogh accounts,
and other retirement plans. Non-IRA,
etc., investors, however, would be paying taxes on the portion of the
interest that accrues each year on such issues, although no cash would
be received until final maturity.
Also, it is pointed out that failure of the issuing corporation
before the lump-sum payoff on zero-coupon bonds would imperil the success
of such issues for investors. The
zero-interest idea has spread to a number of other types of issues including
zero-interest insured certificates of deposit of banks; zero-coupon Eurobonds
(especially active in the London market as of 1982); and non-interest-bearing
receipts sold at discount evidencing claim for principal amount plus accumulated
interest spaced at interim maturities for such receipts, besides the actual
eventual maturity of the U.S. Treasury bonds or state or municipal obligations,
notes, or unit trusts. Non-callable
Treasury issues backed by the full faith and credit of the CATS Certificates
of Accrual on Treasury Securities BIBLIOGRAPHY
DONOGHUE,
W.E. "High-Risk Investments." Executive
Female, November/December 1988. ZERO-COUPON
CONVERTIBLE
Zero-coupon bond with option to convert to common stock. |