Zero coupon bonds:

A bond which pays no coupons, is sold at a deep discount to its face value, and matures at its
face value. A zero-coupon bond has the important advantage of being free of reinvestment risk,
though the downside is that there is no opportunity to enjoy the effects of a rise in market interest
rates. Also, such bonds tend to be very sensitive to changes in interest rates, since there are no
coupon payments to reduce the impact of interest rate changes. In addition, markets for zero-
coupon bonds are relatively illiquid. Under U.S. tax law, the imputed interest on a zero-coupon
bond is taxable as it accrues, even though there is no cash flow.
A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a
price lower than its face value, with the face value repaid at the time of maturity.[1] It does not
make periodic interest payments, or have so-called "coupons," hence the term zero-coupon bond.
When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-
coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds,[1]
and any type of coupon bond that has been stripped of its coupons.

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.

Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the
bond holder is calculated to have a set amount of purchasing power rather than a set amount of
money, but the majority of zero coupon bonds pay a set amount of money known as the face
value of the bond.

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 bonds 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
Zero coupon bonds have a duration equal to the bond's time to maturity, which makes them
sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons
from the principal of coupon bonds, 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. [2]

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 occurs only 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 administered 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
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.

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. [3] 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.

Zero coupon bonds were first introduced in 1960s, but they did not become popular until the
1980s. The use of these instruments was aided by an anomaly in the US tax system, which
allowed for deduction of the discount on bonds relative to their par value. This rule ignored the
compounding of interest, and lead to significant tax-savings when the interest is high or the
security has long maturity. Although the tax loopholes were closed quickly, the bonds themselves
are desirable because of their simplicity.

In India, the tax on income from deep discount bonds can arise in two ways: interest or capital
gains. It is also law that interest has to be shown on accrual basis for deep discount bonds issued
after February 2002. This is as per CBDT circular No 2 of 2002 dated 15th February

The difference between a zero-coupon bond and a regular bond is that a zero-
coupon bond does not pay coupons, or interest payments, to the bondholder while a
typical bond does make these interest payments. The holder of a zero-coupon bond
only receives the face value of the bond at maturity. The holder of a coupon paying
bond receives the face value of the bond at maturity but is also paid coupons over
the life of the bond.

Zero-coupon bondholders gain on the difference between what they pay for the
bond and the amount they will receive at maturity. Zero-coupon
bonds are purchased at a large discount, known as deep discount, to the face value
of the bond. A coupon-paying bond will initially trade near the price of its face value.
In other words, a zero-coupon bond gains from the difference between the purchase
price and the face value, while the coupon bond gains from the regular distribution
of interest.

For example, imagine that you have the choices between a one-year zero-coupon
bond with a face value of $1,000, which can be purchased for $952.38 or a one-year
5% semi-annual coupon bond trading at its face value of $1,000. If you bought the
zero-coupon bond for $952.38, you would receive $1,000 at maturity, which is a gain
of 5% ($47.62/$952.38). If you bought the coupon bond, you would have received
two coupon payments of $25 each during the year for a total of $50, which also
represents a 5% gain ($50/$1,000). So in this case, no matter which bond you buy,
you will get the same return, even though the source of the return is different. This
is not always true, as each case is different.

What Are Zero Coupon Bonds?

What are Zero Coupon Bonds? Zero coupon bonds are bonds which do not make interest
payouts, known as coupon payments, to the bond holder. Instead the bond holder buys the bond
at a discount price off the face value amount, earning zero coupon bonds the nicknames discount
bonds or even deep discount bonds. Essentially the trade-off in a discount bond is one makes
their money, what would be in essence interest of their investment, from the difference between
what they pay for the bond below its par value and the amount they receive, the face value, when
the bond reached maturity. Deep discount bonds were once very popular in the 1960’s when
there existed a very significant tax loophole: no income taxes paid on the profit from discount
bonds. This loophole has since been closed and zero coupon bond holders now are taxed on the
amount of money they make over their initial investment amount as income.
Deep Discount Bonds In The Market
In the marketplace deep discount or zero coupon bonds take on different roles. These bonds can
be issued short or long term. They can be any time of bond in the bond marketplace; they simply
must be stripped of their coupon payments to fit the parameters of a discount bond. Short term
zero coupon bonds issued by the US Treasury department are referred to as bills. Currently these
bills make up the largest market share of discount bonds. Long-term zero coupon bonds can run
anywhere from 10-15 years in maturity length. Most of these bonds are traded on the secondary
bond market and the original investor is rarely the same who holds the bond when it matures. As
bond rates rise or fall bond investors will look to sell these discount bonds at a profit or invest in
them when their value is lowered.