Why Do Companies Sell Debt Having Zero Interest?

Bonds are debt-based financial obligations where the issuer promises to pay the holder a specified amount of money at a certain date in the future. Most bonds issuers also make pre-specified payments of interest to the holder, known as coupon payments. Some bonds, zero-coupon bonds, however, do not make these periodic interest payments and supply the holder with only the bond principal at maturity.

Features

• To investors, the value of a bond comes from two components, the periodic interest payment known as the bond's coupon, and the face value, or principal, of the bond, which is paid at maturity. Together, the present value of the stream of periodic interest payments (typically semiannually or annually) and the present value of the bond's principal comprise the market value of the bond. When no periodic interest payments are made, as with zero-coupon bonds, the entire market value of the bond is derived from the present value of the bond's principal.

Reasons

• There are two primary reasons that companies and governments will issue zero-coupon bonds. First, when the maturity of bonds is short, such as a year or less, there is insufficient time until maturity to make interest payments. Secondly, zero-coupon bonds may be issued when the company or government does not anticipate the revenues to repay a bond will materialize until near the bond's maturity.

Example

• For an example of a project with no immediate revenue base, imagine a state government issuing a bond to build a toll road that will take five years to construct. If the state government intends to finance the debt service on the bond (the interest payments) from toll collections, the government will not be able to pay interest until sometime after the road's completion -- the sixth year. As a result, it may not be sensible for the state government to issue a bond paying interest during the first five years.

Significance

• Because zero-coupon bonds do not pay interest, they are typically sold at a discount from the face value or principal of the bond. Since holders of the bond receive the full face value at maturity, the discount from face value compensates the holder for the interest they would have received had the bond paid a coupon. The most common types of zero-coupon bonds are United States Treasury bills and United States savings bonds.

Taxation

• In the United States, many bonds are issued with interest payment coupons even if it may not be sensible for the issuer to do so. The reason for this is that the Internal Revenue Code requires investors to calculate an imputed amount of interest on the bonds. The income related to this interest must be paid annually even though the face value of the bond has not been received. To make bonds more attractive to investors, many bond issuers will attempt to structure their bonds to avoid this imputed interest requirement.