What are interest-free bonds and how do they work?

Interest-free bond Eng. Zero-Coupon Bond or Accrual Bond , a debt security for which interest is not paid, and its sale occurs at a discount (below the face value). Profit on the expiration of the circulation period occurs as a result of reimbursement to the investor of the full nominal value.

Since interest-free bonds assume a one-time payment at the end of the maturity period, they are more prone to fluctuations in market prices than coupon bonds.

In our most recent Concept of Economy , we talk about What are the letters, bonds and obligations and how do they work? where we explain how bonds are valued and how the profitability for investors is calculated. As we see in the graph, debt securities have several elements to take into account to calculate profitability. There is a type of debt that has one less element than the normal ones, which is debt without interest and this is the subject of our Concept of Economy today.

Characteristics of the interest-free bond

The main feature of the interest-free bond that sets it apart from other bonds is that it carries no interest during its period. In other words, it only has two movements of funds, the initial investment by the investor and the final repayment by the issuer of the debt.

Since no interest is paid during the period, when it is due, the final repayment takes into account the amount borrowed and the equivalent of all the interest on the bond not paid during the period.

With interest-free bonds, investors seek to receive the same type of return for the term and risk of the debt issuer. To set the investment price, it is necessary to see the issuer’s risk premium and the interest that is being paid for the term sought.

Issue price

When the profitability that an investor must pay has been calculated, the profitability formula is reformulated to the one we see on the right (in this example, they divide the interest and multiply the number of payments because the interest is paid every six months), to establish the issue price, that is, that price that offers enough discount for the investor to receive the necessary yield at maturity of the bond without interest, for the term and risk.

Since the only return investors receive is through the principal they receive at the end, this annual return is used to calculate the issue price necessary for the issue, that is, what discount they have to invest at the beginning.

Advantage of interest-free bonds

For issuers, these bonds allow them to borrow without having to disburse amounts in repayments from the first year, and debtors with liquidity limitations in initial periods may want to use this financial instrument that delays payments until the end.

For investors, they can organize their portfolios to ensure that their liquidity needs are met. For example, if an investor has a payment due in three years, he can buy an interest-free bond today, with a term of three years , to ensure that, in three years, he has the necessary liquidity. The purchase price would be calculated with the aforementioned formula, and will be less than the principal due, since the investor would not be receiving interest during these three years.

Bonds without artificial interest

In the 1980s, artificial interest-free bonds, called Strips, were invented where they took normal bonds and separated all payments to sell to separate investors . As an example, a € 10 million bond with a five-year term that pays 6% interest per year, with interest paid annually, has the following 6 total payments:

  • an interest payment of € 600,000 in one year.
  • an interest payment of € 600,000 in two years.
  • an interest payment of € 600,000 in three years.
  • an interest payment of € 600,000 over four years.
  • an interest payment of € 600,000 in five years.
  • a principal payment of € 10 million in five years.

What they did on Wall Street is buy the bond in the market and then sell the different payments separately to different investors and sold them at prices calculated with the formula mentioned above for the different terms to set the discount for the sale.

Conclusions

These interest-free bonds, like other bonds, are tradable on the secondary market and, since they do not have interest payments, any change in the level of interest in general and the level of the risk premium is reflected in changes in their price. This makes the price of the bond without interest much more volatile to changes in the market than other bonds. Although the price of interest-free bonds is volatile, by approaching one to the maturity years, the price will increasingly approach 100%, which is what the issuer will return to the investor.

Fiscally, they may have different treatment, depending on whether the increase in the principal of the bond is considered as a capital increase, compared to the interests that are considered income . In the United States, as in many other places, they impute the theoretical increase to the price and this is taxed as an income every year. This is a disadvantage since the investor incurs a fiscal cost without having received the interest income. By cons, at maturity, the investor would not pay taxes on the price increases in which taxes have already been paid.

Interest-free bonds are one more tool that offers different possibilities, both to the issuer and to the investor, for capital investment.

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