Zero-coupon bond

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. It does not make periodic interest payments, or have so-called "coupons," hence the term zero-coupon bond. Investors earn return from the compounded interest all paid at maturity plus the difference between the discounted price of the bond and its par (or redemption) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds,

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

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. This is because any fixed income security can be broken down into individual cashflows and viewed as an equivalent portfolio of zero-coupon bonds. Analysts can then price fixed income securities by discounting each individual cash flow by the appropriate discount rate implied by zero-coupon bonds.

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. 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 2002.

References

Category:Bonds