Legal Definitions - zero-coupon security

A zero-coupon security is a type of investment that does not pay regular interest payments (known as "coupons") to the investor during its life. Instead, it is sold at a price lower than its face value, and the investor receives the full face value of the security when it matures. The investor's profit comes from the difference between the discounted price they paid and the higher face value they receive at maturity.

Here are some examples to illustrate this concept:

• Government Savings Bond: Imagine the U.S. Treasury issues a special 10-year zero-coupon bond. An investor might purchase this bond today for $7,500. Throughout the next ten years, they will not receive any interest payments. However, when the bond reaches its maturity date in ten years, the investor will receive the full face value of $10,000. The $2,500 difference ($10,000 - $7,500) represents their return on investment, which is realized all at once at the end of the term.

• Corporate Financing: A growing technology company needs to raise capital for a new project but wants to avoid making periodic interest payments that could strain its cash flow in the short term. It decides to issue a 5-year zero-coupon bond. An investor buys one of these bonds for $850. For five years, the investor receives no payments. At the end of the five years, the company repays the investor $1,000 (the bond's face value). This arrangement allowed the company to defer its borrowing costs, and the investor earned a return by purchasing the bond at a discount.

• Educational Savings: A parent wants to save for their child's college education, which is 15 years away. They decide to invest in a zero-coupon municipal bond. They purchase the bond for $6,000. This bond will not pay any interest annually. However, when the bond matures in 15 years, it will be worth $10,000. This strategy allows the parent to lock in a future value for their savings without having to reinvest periodic interest payments, making it a straightforward way to save for a specific future goal.