A yield to maturity zero coupon bond is a bond that is unusual in that it provides no regular interest payments to the person who holds it. Instead, the bondholder is guaranteed the face value of the bond when it reaches maturity. The bonds are purchased at a discount to their face value, since the bonds accrue interest throughout their duration based on some predetermined interest rate until they reach the stated yield upon their maturity. Should a person holding a yield to maturity zero coupon bond attempt to sell it in the secondary market, he or she will find that the bond's value will be affected by prevailing interest rates.
Bonds are used by institutions like corporations and governments as a way to raise money, while investors favor them because they receive fixed income while they hold these bonds. In the case of normal bonds, the investor will pay a principal amount to purchase one and then will receive regular interest payments at a predetermined rate known as the coupon before eventually receiving the return of principal if the bond is held to its maturity. There is, however, a unique type of bond known as a yield to maturity zero coupon bond that promises no regular interest payments but can still benefit investors.
While interest payments are not received by the investor throughout the life of the bond, it is important to realize that a yield to maturity zero coupon bond does involve interest. The difference between a zero bond and others is that the interest accrues. If the bond is held to maturity, the interest will receive all of the accrued interest, which, added to the original premium payment, adds up to the face value of the bond.
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The interest on a yield to maturity zero coupon bond is stated when the bond is purchased and generally compounds semi-annually throughout the life of the bond. Investors pay an amount that is discounted from the face value to buy the bond. This discount is based on the interest rate and the duration. As the duration increases, so does the discount, since there is more time for the bond to accrue interest.
Investors who purchase a yield to maturity zero coupon bond have the comfort of knowing exactly what they will receive should they hold the bond to maturity, but there is still risk involved. Rising interest rates will devalue the bond, since newly issued bonds with the higher rates are more valuable. This can cause a problem to investors trying to sell a zero bond in the secondary market. High inflation that rises up above the interest rate of the zero bond can also be damaging to its value.