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What is a Zero Coupon Bond?

by: sahil | last updated: April 12, 2010
Category: Personal Finance | Tags: zero coupon bonds, discount bond, deep discount bond, bonds, investing

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What is a Zero Coupon Bond?

A zero coupon bond is one which is bought at a lower price than its face value and is also referred to as a deep discount bond or a discount bond. The face value of such bonds is repaid at the maturity of these bonds. It does not make cyclic interest payments, or have so-called “coupons,” therefore the term zero-coupon bond. Investors receive return from the compounded interest all paid at maturity in addition to the difference between the cut-rate price of the bond and its par (or recovery) price.

Common examples of zero-coupon bonds consist of U.S. Treasury bills, long-term zero-coupon bonds, U.S. savings bonds, and any kind of coupon bond that has been stripped of its coupons. Zero coupon bonds might be long or short term funds. Long-term zero coupon maturity dates normally commence at ten to fifteen years. The bonds can be held pending maturity or traded in secondary bond markets. Short-term zero coupon bonds usually have maturities of less than one year and are also referred to as bills. The U.S. Treasury bill market is the most dynamic and liquid debt market on the globe.

Zero coupon bonds have a length equivalent to the bond’s moment to maturity, which makes them susceptible to any alterations in the interest rates. Investment banks or dealers might detach coupons from the principal of coupon bonds, which is also referred to as the residue, so that various investors can obtain the principal and each of the coupon payments. This generates a steady supply of fresh zero coupon bonds.

The coupons and residue are traded individually to investors. Every one of these investments then generates a single lump sum. This technique of creating zero coupon bonds is also called as stripping and the contracts are referred to as strip bonds. The acronym “STRIPS” stands for Separate Trading of Registered Interest and Principal Securities.

Zero coupon bonds were originally launched in the 1960’s, but they did not become fashionable until the 1980’s. The use of these instruments was aided by a glitch in the US tax system, which permitted for subtraction of the discount on bonds relative to their par value. This law disregarded the compounding of interest, and showed the way for momentous tax-savings when the interest is lofty or the security has long maturity. Even though the tax dodges were blocked rapidly, the bonds themselves are attractive because of their straightforwardness and simplicity.

In the US, the holder might be legally responsible for imputed earnings (sometimes called phantom income), albeit these bonds do not give recurring interest. For this reason, zero coupon bonds that are subject to U.S. taxation should usually be held in tax-deferred retirement accounts, to circumvent paying taxes on potential earnings. On the other hand, when acquiring a zero coupon bond given by a U.S. state or neighboring government body, the imputed interest is free of U.S. federal taxes and in the majority of cases, including the state and local taxes as well.