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 convertibleszero 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 1special considerationsthe 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 convertibleszero 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 investopedia does not provide tax investment or financial services and advice the information is presented without consideration of the investment objectives risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors investing involves risk including the possible loss of principal 