What is a zero-coupon security

In a typical bond, the payment of a bond = principal + coupons

For a zero-coupon bond, payment = principal.

That is, zero-coupon securities (aka zeros) are securities that pay no coupon.

But why on this green earth do you think I buy a bond that pays no interest? To address is question. Zeros are traded at a discount price so that you get a positive yield

e.g. Today you buy a zero that pays you $100 a year later, at the price of $99. Then the yield is ($100 / $99) - 1 = 1.01%

The formula for zero yield calculation:

Benefits of zeros:

• For issuers: There’s negligible servicing requirement in the years before bond redemption, so zero issuance is favored by those who have a cash flow problem
• For investors: a higher proportion of return is in capital gain than the interest payment. This can be a big win under certain taxation conditions. Usually, long-term capital gains are exempt from tax

Risks of zeros:

• Interest rate risk: The duration and convexity of zeros are typically higher than coupon-paying security of the same term to maturity. Therefore zeros are more susceptible to interest increase.
• Credit risk: The longer the maturity, the more risk of default. Corporate zeros carry the greatest risk of default.

Advanced reading:

Zeros convertible

Zeros convertible are allowed to be converted to common stocks under certain conditions.

This gives an advantage of a run-up in the stock price. For this, zero convertibles are valued more than regular zeros

There are also zeros munis convertible, which can be converted to interest-paying securities.

Deferred Interest (DI) bonds

DI pays no interest for an initial period, typically fro 3~ 7 years. However, interests are accrued and paid at the end.