Coupon bonds and zero-coupon bonds are two common types of bonds, and they differ primarily in how they provide returns to investors and how they are priced. Here are the key differences between coupon bonds and zero-coupon bonds:
1. Interest Payments:
– Coupon Bonds: Coupon bonds pay periodic interest payments (coupons) to bondholders throughout the bond’s life. These interest payments are typically made semiannually and represent a fixed percentage of the bond’s face value (par value).
– Zero-Coupon Bonds: Zero-coupon bonds, as the name suggests, do not make periodic interest payments. Instead, they are issued at a discount to their face value and provide a return to investors when they mature.
2. Pricing:
– Coupon Bonds: The price of a coupon bond is determined by the present value of its future cash flows, which include both the periodic coupon payments and the return of the face value at maturity. Investors pay a premium, par value, or a discount on the face value, depending on prevailing market interest rates and the bond’s coupon rate.
– Zero-Coupon Bonds: Zero-coupon bonds are issued at a significant discount to their face value. The price of a zero-coupon bond is typically lower than its face value because it doesn’t pay periodic interest. The investor receives the full face value at maturity, and the difference between the purchase price and face value represents the investor’s return.
3. Yield:
– Coupon Bonds: The yield on a coupon bond is the yield to maturity (YTM), which takes into account both the coupon payments and the difference between the purchase price and the face value. YTM reflects the total return an investor can expect if they hold the bond until maturity.
– Zero-Coupon Bonds: The yield on a zero-coupon bond is equal to its yield to maturity. Since there are no periodic interest payments, the yield is determined solely by the difference between the purchase price and the face value. As the bond approaches maturity, its yield converges to the YTM.
4. Cash Flow:
– Coupon Bonds: Investors receive regular cash flow from coupon payments, which can be reinvested or used for other purposes. These cash flows provide income during the bond’s life.
– Zero-Coupon Bonds: Investors do not receive periodic cash flows. Instead, they purchase the bond at a discount and receive a single, larger payment at maturity, which may result in a capital gain.
5. Risk and Volatility:
– Coupon Bonds: Coupon bonds are generally less sensitive to interest rate changes compared to zero-coupon bonds because the coupon payments provide some income stability. However, they are still subject to price fluctuations in response to interest rate movements.
– Zero-Coupon Bonds: Zero-coupon bonds are more sensitive to changes in interest rates because their returns are entirely based on the difference between the purchase price and face value. As interest rates rise, the prices of zero-coupon bonds tend to fall more dramatically.
In summary, coupon bonds provide periodic interest payments and have a more predictable income stream, while zero-coupon bonds do not pay periodic interest and are sold at a discount to face value, providing a single, lump-sum return at maturity. The choice between the two depends on an investor’s income needs, risk tolerance, and interest rate outlook.