What Is a Zero-Coupon Convertible?

A zero-coupon convertible is a fixed income instrument that combines the features of a zero-coupon bond with that of a convertible bond.

Due to the zero-coupon feature, the bond pays no interest and is therefore issued at a discount to par value, while the convertible feature means that bondholders have the option to convert bonds into common stock of the issuer at a certain conversion price.

Understanding Zero-Coupon Convertibles

Zero-coupon convertibles marry two features: zero-coupons and convertibles. A zero-coupon security is a debt instrument which does not make interest payments. An investor purchases this security at a discount and receives the face value of the bond on the maturity date. Because there are no payments prior to maturity, zero-coupons have no reinvestment risk. A convertible security is a debt instrument that can be converted into equity of the issuing company at a given time. This is essentially an embedded put option that gives bondholders the right to convert bonds into shares, and acts as a sweetener for investors who get to participate in any upside in the price of the issuer's stock.

A zero-coupon convertible is, thus, a non-interest paying bond that can be converted into the equity of the issuing company after the stock reaches a certain price. An investor who purchases this type of security pays a discount for foregoing any interest income. These bonds, however, tend to also benefit shareholders who can use the conversion option to profit on the exchange for shares, and who maintain priority ahead of equity holders as a creditor in the case of bankruptcy if the bonds are not converted.

However, these financial instruments have a built-in option which allows the issuer to force the conversion of the bonds when the stock performs as expected, capping the investor's upside potential. In addition, zero-coupon convertibles tend to be somewhat volatile in the secondary market because the convertible option may or may not become valuable, depending on how the company performs over the life of the debt instrument.

A zero-coupon convertible can also refer to a zero-coupon issued by a municipality that can be converted to an interest-paying bond at a certain time before the maturity date. When a municipal government issues these muni convertibles, they are tax-exempt, but are also convertible to other bonds that may yield more.

Special Considerations

The zero-coupon and convertible features offset each other in terms of the yield required by investors. Zero-coupon bonds are often the most volatile fixed-income investments because they have no periodic interest payments to mitigate the risk of holding them. As a result, investors demand a slightly higher yield to hold them. On the other hand, convertibles pay a lower yield compared to other bonds of the same maturity and quality because investors may be willing to pay a premium for the convertible feature.

The issuer of zero-coupon convertible increases the principal of the convertible security each year to compensate investors for the absence of coupons. A zero-coupon convertible and interest-paying convertible with identical maturity and call provisions will have approximately the same conversion premium despite the difference in compensation to bondholders.

Pricing Zero-Coupon Convertibles

Zero-coupon convertibles are priced using option pricing models such as the Black-Scholes model; tree-based models(such as the binomial or trinomial model); or the dividend valuation model.

The underlying share price, assumptions about the behavior of the price, assumed equity valuation, and an assumed volatility level are inputs required to price the security. Due to the complexity of zero-coupon convertibles, only sophisticated investors typically trade them.

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