Zero Coupon Bonds

Man, this is hilariously funny. I overheard an apparent "outsider" talking about some company issuing a zero coupon bonds in its capital structure.

This was roughly what he said

"The company XXX is so goooood, decided to do zero couple instead of these bonds that need to pay interest to bondholder, this saves the company many many bank interest".

By the way, sorry for the broken english, I tried to resemble the original wordings from that guy.

Perhaps any educated investor would point out the problem with his statement. Well, most of us could laugh at him after we did some studies on wth is zero coupon. And well, only if most of us aren't lazy.

Firstly, Yes, Zero couple bonds doesn't pay interest. Emmm, it really depends on how you define "interest". More precisely, I must say Zero Couple Bonds doesn't make Coupon Payment to Bond Holders. A Coupon is like an obligation of the bond issuer to make periodic interest give out to bond holders as a way to compensate investors for taking risks in buying the bonds.

So, if Zero Coupon Bonds doesn't do that, how do investors making profit from it?

It is just like U.S. Treasure Bills.

Fine! You might not know T-Bills. What about Pure discount instruments?

Ok! You have no idea what am I talking about.

Great, now I have to tell the story using my own words, and please don't whack me if my understanding deviates from those well established in the financial literatures.

Imagine a fictionous scenario that you want to eat an apple and an apple is selling at USD100 in the market. The problem is you don't have USD100 and now you hunting out to find ways to get your apple. And then there is another guy, who desperately want to grow apple trees and therefore he need some money to do his business. So he decided to offer a deal in the market. The deal is he will promise to pay USD100 at the deal maturity, let say 6 months, in return for USD80 that you provide to him immediately. If you can wait for 6 months and if you still want to eat your apple, then this is possibly a good deal that you might want to engage.

(At this point, if you know about Derivatives, you might think that the above scenario is also applicable to derivatives trading. No, you are wrong. In the above case, the amount of money exchanged hand/specified in the contract is fixed, hence the term Fixed Income Securities)

Assume that you signed up the deal, paid USD80 upfront and waited for 6 months for your USD100, your Holding Period Return (HPR) is

= (USD100 - USD80)/ USD80
= 25% (Not Bad huh)

The point here is Zero Coupon Bonds like the scenario, will allow you to purchase the bond at a discounted price, then by holding it to maturity, you shall redempt it at full value, i.e. par value/face value. No interim interest payment shall be made to you though.

Ok, Ok. I heard some noises at the back. What's that? Oh, you're asking what are reasons for corporates to choose between zero coupon and coupon bearing then.

Plenty of reasons, of course.

But, in my opinion, only one reason is significant: To manage/manipulate financial reports/ratios. To understand the implication of choosing amongst the two, we need to understand how companies record the bonds transaction in their book.

Oh boy, I've typed some many words and got lazied. So, I will just summarized this up.

Basically, coupon bearing bonds can be categorized into 3 groups: bonds at par, discount bonds and premium bonds and each is recognized by the different between coupon interest rate and market rate of interest at issuance; and each have impact on CFO and CFF.

Anywaym, because interest payments are recognized as interest expenses in income statement, therefore for zero coupon bonds, the profit is significantly overstated because CFO is significantly high due to the absence of substraction effect of coupon payments. "Interest" payment of zero coupon bonds is only realized the maturity and only in CFF. Other than this, ratios such as debt-to-equity will also be distorted.

Ok, that's all for now.