You can calculate the present value of a zero coupon bond using a formula involving the stated yield return , the par or face value, and the time until maturity when the bond's par or face value will be paid out to the bond holder. To create this article, volunteer authors worked to edit and improve it over time. This article has also been viewed 65, times.
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Categories: Financial Bonds. Learn why people trust wikiHow. Author Info Updated: March 29, Learn more Add 1 to the required interest rate on the bond.
The required interest rate or "yield-to-maturity" is the rate of return that a bond is presumed to require in order to entice investors to purchase the bond. Generally, bonds that are riskier will require a higher rate of return in order to attract buyers. Risks can include the potential for default the bond issuer being unable to pay back the bond holder or the risk of a future increase in the interest rate of new bonds, which will decrease the attractiveness relative value of the present bond.
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Also the longer the remaining time until the bond matures and pays out its final value, the riskier the bond is simply because of the increased potential for payout problems inherent in longer periods of time. Thus, for purposes of this formula, you would add 1 to 0. Determine the number of time periods years in this case remaining until the bond matures.
For example, if the bond issuer will pay the bond holder the face value of the bond in five years, then the time-to-maturity is five. Take the sum calculated in Step 1 above and raise it to the power of the remaining time period. Thus, 1.
Zero Coupon Bond Calculator
On a calculator, you would multiply 1. Divide the par face value of the bond by the result of the previous step. When solved, this equation produces a value of 0. Time value of money formulas usually require interest rate figures for each point in time. This consequently renders the yield to maturity easier to calculate for zero-coupon bonds.
There are no coupon payments to reinvest, making it equivalent to the normal rate of return on the bond. The yield to maturity may change from one year to the next. It depends on changes in the overall prices in the bond market. For example, suppose that investors become more willing to hold bonds due to economic uncertainty. Then bond prices would likely rise, which would spike the denominator in the yield to maturity formula, thereby reducing the yield.
Yield to maturity is an essential investing concept used to compare bonds of different coupons and times until maturity. 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.
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Zero-coupon bonds trade on the major exchanges. They are commonly issued by corporations, state and local governments, and the U. Corporate zero-coupon bonds are usually riskier than similar coupon-paying bonds.
If the issuer defaults on a zero-coupon bond, the investor has not even received coupon payments, so the potential losses are higher. The IRS mandates a zero-coupon bondholder owes income tax that has accrued each year, even though the bondholder does not actually receive the cash until maturity. The IRS calls this imputed interest.
Zero-coupon bonds often mature in ten years or more, so they can be long-term investments. The lack of current income provided by zero-coupon bonds discourages some investors. Others find the securities well suited for achieving long-term financial goals, such as saving for a child's college expenses.
With the discounts, the investor can grow a small amount of money into a substantial sum over several years. Zero-coupon bonds essentially lock the investor into a guaranteed reinvestment rate. This arrangement can be most advantageous when interest rates are high and when placed in tax-advantaged retirement accounts. Some investors also avoid paying taxes on imputed interest by buying zero-coupon municipal bonds. They are usually tax-exempt if the investor lives in the state where the bond was issued.
With no coupon payments on zero-coupon bonds, their value is entirely based on the current price compared to face value.