The bond you describe is an example of a zero-coupon or discount bond. The name derives from the fact that the bond pays no coupon or interest while the investor holds it. However, if the investor holds it to maturity, then presumably the payment is enough to return the original investment and a surplus to reward the bondholder for making the investment in the first place. The face value of a discount bond exceeds the investment.

The entire return, if the bond is held to maturity, comes at the end of the bond’s term. For example, if the investor purchases a ten-year bond and holds it to maturity, at the end of ten years the investor receives a repayment of the money plus the surplus. If the bond has a 20-year term, then the repayment comes after 20 years and so on.

If the bond has a face value of $1,000 and the investor purchases it for $800, then upon maturity the investor receives $1,000. This represents a return of principal plus $200 imputed interest, which equates to an interest rate of 20%. The investor must decide whether 20% is sufficient reward to warrant the investment.

Just as with any other purchase, people weigh the price versus the perceived value of purchase. Nearly everyone would want to have a dinner out at a fancy restaurant, but people decide whether or not to invest in the dinner based on the price. Similarly, an investor would want to buy a discount bond if the purchase price is sufficiently attractive to warrant the investment. The decision must take into account the time value of money. If the investor can purchase either a zero-coupon bond or a bond that pays interest at identical interest rates, most investors would not choose the zero-coupon bond because there is a value to receiving the interest earlier. The interest payments could be reinvested in another investment that also yields a return.

## We’ll help your grades soar

Start your 48-hour free trial and unlock all the summaries, Q&A, and analyses you need to get better grades now.

- 30,000+ book summaries
- 20% study tools discount
- Ad-free content
- PDF downloads
- 300,000+ answers
- 5-star customer support

Already a member? Log in here.

Are you a teacher? Sign up now