Types of Bonds

Zero-Coupon Bonds

Zero coupon bonds were first introduced in the 1960s, but they did not become popular until the 1980s. A zero-coupon bond (also called a "discount bond" or "deep discount bond") is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments or have so-called "coupons," hence the term zero-coupon bond. When the bond matures, its investor receives its par (or face) value. Zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, and long-term zero-coupon bonds.

SMAC bond Bond on VMOK with the signature on Boris Saraf.

Zero-coupon bonds may be created from fixed-rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. Investment banks or dealers separate coupons from the principal of coupon bonds, which is known as the "residue," so that different investors may receive the principal and each coupon payment.

This creates a supply of new zero-coupon bonds. The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping, and the contracts are known as strip bonds. "STRIPS" stands for Separate Trading of Registered Interest and Principal Securities.

Zero-coupon bonds may be long- or short-term investments. Long-term zero-coupon maturity dates typically start at 10 to 15 years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero-coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market globally.

Zero coupon bonds have a duration equal to the bond's time to maturity, which makes them sensitive to any changes in interest rates. The impact of interest rate fluctuations on strip bonds is higher than coupon bonds.

Pension funds and insurance companies like to own long-maturity zero-coupon bonds because of the bonds' high duration. This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate and, therefore, offset or immunize the interest rate risk of these firms' long-term liabilities.