Issuers

In the U.S., government sponsored enterprises (GSEs) such as the Federal Home Loan Banks, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are important issuers. In Europe the main issuers are banks.

Variations

Some FRNs have special features such as maximum or minimum coupons, called capped FRNs and floored FRNs. Those with both minimum and maximum coupons are called collared FRNs.

FRNs can also be obtained synthetically by the combination of a fixed rate bond and an interest rate swap. This combination is known as an Asset Swap.

Risk

FRNs carry little interest rate risk. If market rates rise, a fixed rate bond declines in value. However, the expected coupons of the FRN increase in line with the increase in forward rates. This means the price remains constant. As FRNs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is credit risk.

Trading

Securities dealers make markets in FRNs. They are traded over-the-counter, instead of on a stock exchange. In Europe, most FRNs are liquid, as the biggest investors are banks. In the US, FRNs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRNs are typically quoted as a spread over the reference rate.

Trading example

Suppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%, and is issued at par (100.00). If the perception of the credit-worthiness of the issuer goes down, investors will demand a higher interest rate, say LIBOR +0.25%. Therefore, a dealer would then make a market of 27 / 25. This means, that he would buy bonds at the equivalent of LIBOR +0.27%, and sell at the equivalent of LIBOR +0.25%. If a trade is agreed, the price is calculated. In this example, LIBOR +0.27% would be roughly equivalent to a price of 99.65. This can be calculated as par, minus the difference between the coupon and the price that was agreed (0.07%), multiplied by the maturity (5 year).

In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.

Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets.

Short term zero coupon bond generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.

Strip bonds

Investment bankers or dealers may separate the coupons from the bond principal, which is known as the residue, so that different investors may receive the principal and each of the coupon payments. This creates a supply of new zero coupon bonds.

The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds. "STRIPS" stands for Separate Trading of Registered Interest and Principal Securities.

Dealers normally purchase a block of high-quality and non-callable bonds - often government issues - to create strip bonds. A strip bond has no reinvestment risk because the payment to the investor only occurs at maturity.

The impact of interest rate fluctuations on strip bonds, known as the bond duration, is higher than for a coupon bond. A zero coupon bond always has a duration equal to its maturity, a coupon bond always has a lower duration. Strip bonds are normally available from investment dealers maturing at terms up to 30 years. For some Canadian bonds the maturity may be over 90 years.

In Canada, investors may purchase packages of strip bonds, so that the cash flows are tailored to meet their needs in a single security. These packages may consist of a combination of interest (coupon) and/or principal strips.

In New Zealand, bonds are stripped first into two pieces - the coupons and the principal. The coupons may be traded as a unit or further subdivided into the individual payment dates.

In most countries, strip bonds are primarily administerd by a central bank or central securities depository. An alternative form is to use a custodian bank or trust company to hold the underlying security and a transfer agent/registrar to track ownership in the strip bonds and to administer the program. Physically created strip bonds (where the coupons are physically clipped and then traded separately) were created in the early days of stripping in Canada and the U.S., but have virtually disappeared due to the high costs and risks associated with them.

Uses

Pension funds and insurance companies like to own long maturity zero coupon bonds because of the bonds' high duration. This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate, and therefore offset, or immunize the interest rate risk of these firms' long-term liabilities.

Yield curve traders and academics use zero coupon bonds to precisely analyze the yield curve. Coupon bonds inherently mix different cash flows and interest rates, but by limiting cash flows to a single payment, zero coupon bonds enable analysts to separate out the effect of a single interest rate for each time period.

Taxes

In the United States, the holder may be liable for imputed income (sometimes called phantom income), even though these bonds don't pay periodic interest [1]. Because of this, zero coupon bonds subject to U.S. taxation should generally be held in tax-deferred retirement accounts, to avoid paying taxes on future income. Alternatively, when purchasing a zero coupon bond issued by a U.S. state or local government entity, the imputed interest is free of U.S. federal taxes, and in most cases, state and local taxes, too.

*Unfortunately, income taxes bring some inflation risk back to such bonds. See tax on the inflation tax

Underlying Mechanism

A common misconception about these bonds is that the interest rate changes with inflation. What actually happens is that the underlying principal of the bond changes, which results in a higher interest payment when multiplied by the same rate. For example, if the coupon of a bond was 5%, and the underlying principal of the bond was 100 units, the bond would pay 5 units, assuming annual payments. If the inflation index then increased by 10%, the principal of the bond would then increase to 110 units. This is multiplied by the same coupon rate of 5%, which results in an interest payment of 5.5 units. The only known exception to this is the Australian Capital Indexed Bond, which also adjusts the interest rate.

Global issuance

Best known in the U.S. are Treasury Inflation-Protected Securities (TIPS), a type of US Treasury security. The U.K. also issues Index-linked Gilts. The Australian government stopped issuing the Capital Indexed Bond in 2003. The Australian bond was unique among inflation-linked bonds in that the rate of interest and the principal were both linked to inflation. France, Canada, Greece, Italy, Japan, and Sweden also issue Inflation Indexed Bonds.