Zero Coupon bond is a bond that is purchased at a discounted price i.e. at a price that is lower than the actual face value of the bond.
Unlike other bonds which regularly pay interest (coupons) during the duration of the bond and pay the principal amount at the time of the maturity. Zero coupon bonds do not pay the interest in the form of coupons regularly. Instead, the compound interest is paid at the time of maturity along with the difference between its redemption value and the price at which the bond was bought.
Zero coupon bonds are also called as discount bonds, accrual bonds or deep discount bonds. Introduced in 1960s, zero coupon bonds became popular around the world only in 1980s.
Some zero coupon bonds are dependent on inflation. If inflation is high, then the bond holder is bound to get more profit out of the zero coupon bonds. However, majority of the zero coupon bonds will pay only the face value of the bond along with the compound interest. Any kind of fluctuation in interest rates have a direct impact on the zerocoupon bonds. If the interest rates are high in the market, zero coupon bonds are likely to benefit its holders. However, if the interest rates are going down, it may adversely affect the zero coupon bonds holders.
Some financial institutions, banks or dealers buy high quality bonds, mostly government issues and strip them of their interests or coupons and sell them as zero coupon bonds. This allows financial institutions, banks and dealers to sell the coupons or interest and principal amount of the bond to different investors. Such types of bonds are known as Strip (Separate Trading of Registered Interest and Principal) bonds.
While normal bonds have a lower duration, zero coupon bonds’ duration exists up till its maturity.
People may buy either long term zero coupon bonds or short term zero coupon bonds. Long term zero coupon bonds have maturity period of 10 to 30 years. In Canada, some long term zero coupon bonds have maturity period of 90 years.
Short term zero coupon bonds are known as bills and have maturity period of less than one year. US Treasury bill is the best example of Short term Coupon Bonds.
Zero coupon bonds are favored by pension funds and insurance companies since the duration of these bonds is long which can help balance the interest rate risk involving long term liabilities of these firms.
Though zero coupon bonds do not pay interest regularly, bond holders in the United States may have to pay tax on imputed income or phantom income. So in order to avoid taxes on future income, the bond holders in US prefer to purchase bonds issued by US state or local governments like municipal zerocoupon bonds as no taxes have to be paid for bonds issued by state or local governments. Also, the bond holder can hold the zero coupon bond in retirement accounts since these accounts are tax free. Some corporate too issue zero coupon bonds are exempted from paying tax.