How zero coupon bonds work
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Zero coupon bonds may sound like a bad idea but there are ways to make them work for investors and SMEs.
Zero coupon bonds are bonds that do not pay interest periodically and are usually sold with a very deep discount from face value. The investor receives a return based on the gradual appreciation of the security. The investor is then able to redeem their return on a specified maturity date.
How do they work?
Zero coupon bonds are usually long term investments, on quoted markets they traditionally take at least ten years or more to mature. An investor buys Company X’s bonds at a highly discounted rate on the basis that they hope the bond will increase in value with a longer maturity period.
Most bonds offer investors regular interest payments with the investor receiving their initial investment upon maturity. Zero coupon bonds don’t do this – instead investors receive one payment at maturity which is equal to their initial investment plus the interest earned, compounded semi-annually, at a pre-stated yield. Basically a zero coupon bond only pays out interest at the end of the coupon’s term in one lump sum.
Why would anyone invest in Zero coupon bonds?
Let’s be honest, they’re not for everyone – they can be higher risk because the business offering them is more likely to be at an early stage, and the maturity period can be much longer than most other bond types.
So who would invest in them? Possibly someone who wants to further diversify their investment portfolio. Another reason may be that an investor wants to make a much longer term investment for a much smaller initial layout.
The long term maturity dates mean that an investor can put up a small amount of money that can grow over many years. If the term is ten years or more, they are much less liquid than mini-bonds which tend to have a maturity date of between two to five years. The difference being of course that the cost will not be as heavily discounted and no interest is earned in the interim before maturity.
Saying that, some zero coupon bonds can have a shorter duration of four to five years. Also, the interest rate on zero coupon bonds will generally be higher than that of the same company offering bonds with regular coupons over the same duration.
Is a heavily discounted zero coupon bond worth it?
Well that depends on you as investor and how you’ve calculated your potential return (InvestingAnswers.com explain how to calculate the price of a zero coupon bond quite nicely here). CODE Investing believe that they can be one of many ways to diversify your investment portfolio, there are other types of bonds you can purchase that are less risky whilst still offering high returns.
But if the coupon carries other incentives such as an option to convert bonds into shares, this can represent another alternative.
What’s in it for SMEs seeking a business loan?
On the surface a lot – businesses can get a loan for a much longer period of time before they have to pay anything back. Also the business doesn’t have to give up a percentage of the ownership like they would if they were offering equity.
The problem is, because of precisely those two factors they are less appealing to investors. That can mean any business seeking to offer zero coupon bonds may have an uphill battle finding anyone willing to invest.
The simple fact is that other forms of bonds are much more attractive to investors. Non-convertible loans for example offer investors the appeal of regular interest payments and allow the business to retain full ownership. Convertible loans also offer investors regular payments and the opportunity to become a shareholder on maturity.[Read more about Convertible Loans]
How can you make zero coupon bonds more attractive?
One way to make the offer more appealing is to add sweeteners such as offering a convertibility option as mentioned earlier, or free product rewards. A great example of this working would be Hambledon’s raise with CODE Investing in 2015. English sparkling wine producers, Hambledon raised over £3,500,000.00 through zero coupon bonds which included a convertibility option and wine rewards for investors.
For us at CODE Investing, we believe that the most important part of any investment offer is the due diligence performed on the business. We’re here to support you however you decide to invest or raise funds.
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