A bond is an investment you buy with a lump sum of cash and in return you get a certain amount of money sometime in the future. A typical bond will pay you interest on a regular basis – every six months, for example – plus pay you back your original investment when the bond matures at a predetermined time. Whether the interest compounds depends on how you look at the bond and also what type of bond you buy.
Zero coupon bonds have a compounding effect unlike other simple bonds that pay simple interest. Even when your type of bond pays simple interest, you may still see a compounding effect depending on how you look at it.
Components of a Bond
A bond has several components that determine your interest payment and return. The money you use to buy the bond is called the par value. The return of your original investment is called the maturity value, and the date at which you get it is called the maturity date.
The interest rate associated with the bond is called the bond return, and the interest payments are called coupons. If you bought a $1,000 bond with a bond return of 6.0 percent, you’d receive $60 in interest during the year ($1,000 x 0.06). If the bond paid semiannual coupons, or twice a year, you’d receive $30 every six months.
Yield to Maturity
Since the bond pays you interest on a regular basis and that interest is not reinvested, you could say the bond pays simple interest and does not compound. You do, however, gain a slight advantage by receiving your coupons more than once a year. If the return on your $1,000 bond is 6.0 percent and your coupons are paid every six months, your $30 interest payments are in fact equivalent to a 3.0 percent interest rate every six months.
You can calculate an equivalent annual rate of return on your investment by calculating how 3.0 percent every six months translates to an annual rate. Use (1+i/n)^n - 1, where i is the bond return and n is your coupon frequency (2 for semiannual, 12 for monthly). So your 3.0 percent interest every six months translates to an annual rate of return of 1.03^2 - 1, or 6.09 percent. That rate of return is called the yield to maturity and uses the effects of compounding your interest payments during a period of one year.
Zero Coupon Bonds
There are bonds you can buy that actually do offer the effect of compounding interest over time. Zero coupon bonds pay you a certain amount of money at the maturity date but do not pay you any interest in the meantime. You buy the bond for less money than you will receive at maturity.
The return on your original investment compared to the maturity value can be viewed as compound interest using the formula PV = MV / (1 + i)^n, where PV is your par value (original investment), MV is your maturity value at time n and i is the compound interest earned on the bond. If a bond offered you a $1,000 maturity value in 20 years at 6.0 percent compound interest, you would pay $1,000 / (1.06)^20, or $311.80.
Considerations for Zero Coupon Bonds
The advantage of a zero coupon bond is you can buy a bond with the same maturity value as a regular bond but at a much lower price, since you are not receiving regular interest payments. In addition, if you buy a municipal zero coupon bond, the interest is usually tax-free. Disadvantages include the fact that you have to wait a long time for your money if you buy a corporate zero coupon bond and you take a risk based on the financial strength of the issuing company.