Zero Coupon Bonds

Zero coupon bonds (also known as pure discount or deep discount bonds) are bonds that do not pay any periodic interest. They compensate the investor by the difference in the price at which they are issued and the maturity value.

Example

Company Z has issued 100,000 $100 face value bonds with a term of 5 years. The company does not want to make any periodic payments so it has priced the bond at $62.1 per bond. In 5 years the company will pay back $100 and an investor would earn $38 ($100 minus $62) as the compensation.

Valuation of a zero-coupon bond

A zero coupon bond is valued by discounting the maturity value of the bond back to the issue date using the current market interest rate.

Example

Company Z has issued 1 $100 face value bonds with a term of 5 years. The company does not want to make any periodic payments and the market interest rate is 10%.

The company would price the bond at $62 determined by discounting $100 for 5 years at 10% (($100/(1+10%)^5).

Accounting for zero coupon bond

At the issuance the company would debit cash and credit bonds payable for $62. At the end of first year end it will debit interest expense and credit bonds payable by an amount of $6.2 (10% multiplied by $62). At the end of second year it will debit interest expense and credit bonds payable by an amount of $6.82 (10% ($62+$6.2)). This procedure would lead to a balance in the bonds payable account of $100 at the end of 5 years. At maturity the company will debit bonds payable and credit cash by $100.

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork