Zero-coupon bond
A zero-coupon bond (also discount bond or deep dis- non-callable bonds—often government issues—to create
count bond) is a bond bought at a price lower than its face strip bonds. A strip bond has no reinvestment risk be-
value, with the face value repaid at the time of maturity.[1] cause the payment to the investor occurs only at maturity.
Note that this definition assumes a positive time value The impact of interest rate fluctuations on strip bonds,
of money. It does not make periodic interest payments,
known as the bond duration, is higher than for a coupon
or have so-called “coupons”, hence the term zero-coupon bond. A zero coupon bond always has a duration equal to
bond. When the bond reaches maturity, its investor re-
its maturity; a coupon bond always has a lower duration.
ceives its par (or face) value. Examples of zero-coupon Strip bonds are normally available from investment deal-
bonds include U.S. Treasury bills, U.S. savings bonds, ers maturing at terms up to 30 years. For some Canadian
long-term zero-coupon bonds,[1] and any type of coupon bonds the maturity may be over 90 years.
bond that has been stripped of its coupons.
In Canada, investors may purchase packages of strip
In contrast, an investor who has a regular bond receives bonds, so that the cash flows are tailored to meet their
income from coupon payments, which are made semi- needs in a single security. These packages may consist
annually or annually. The investor also receives the prin- of a combination of interest (coupon) and/or principal
cipal or face value of the investment when the bond ma- strips.
tures.
In New Zealand, bonds are stripped first into two
Some zero coupon bonds are inflation indexed, so the pieces—the coupons and the principal. The coupons may
amount of money that will be paid to the bond holder
be traded as a unit or further subdivided into the individ-
is calculated to have a set amount of purchasing power ual payment dates.
rather than a set amount of money, but the majority of
zero coupon bonds pay a set amount of money known as In most countries, strip bonds are primarily adminis-
the face value of the bond. tered by a central bank or central securities depository.
An alternative form is to use a custodian bank or trust
Zero coupon bonds may be long or short term invest- company to hold the underlying security and a transfer
ments. Long-term zero coupon maturity dates typically agent/registrar to track ownership in the strip bonds and
start at ten to fifteen years. The bonds can be held until to administer the program. Physically created strip bonds
maturity or sold on secondary bond markets. Short-term (where the coupons are physically clipped and then traded
zero coupon bonds generally have maturities of less than separately) were created in the early days of stripping in
one year and are called bills. The U.S. Treasury bill mar- Canada and the U.S., but have virtually disappeared due
ket is the most active and liquid debt market in the world. to the high costs and risks associated with them.
1 Strip bonds 2 Uses
Zero coupon bonds have a duration equal to the bond’s Pension funds and insurance companies like to own long
time to maturity, which makes them sensitive to any maturity zero-coupon bonds because of the bonds’ high
changes in the interest rates. Investment banks or deal- duration. This high duration means that these bonds’
ers may separate coupons from the principal of coupon prices are particularly sensitive to changes in the interest
bonds, which is known as the residue, so that different in- rate, and therefore offset, or immunize the interest rate
vestors may receive the principal and each of the coupon risk of these firms’ long-term liabilities.
payments. This creates a supply of new zero coupon
bonds.
The coupons and residue are sold separately to investors. 3 Taxes
Each of these investments then pays a single lump sum.
This method of creating zero coupon bonds is known In the United States, a zero-coupon bond would have
as stripping and the contracts are known as strip bonds.
Original issue discount (OID) for tax purposes.[3] Instru-
“STRIPS” stands for Separate Trading of Registered ments issued with OID generally impute the receipt of in-
Interest and Principal Securities. [2] terest (sometimes called phantom income), even though
Dealers normally purchase a block of high-quality and these bonds don't pay periodic interest. [4] Because of
1
2 4 REFERENCES
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 the 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 led 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 a law
that interest has to be shown on an accrual basis for deep
discount bonds issued after February 2002. This is as per
CBDT circular No 2 of 2002 dated 15 February 2002.
4 References
[1] Mishkin, Frederic S. (2007). The Economics of Money,
Banking, and Financial Markets (Alternate Edition). New
York: Addison Wesley. p. 70. ISBN 0-321-42177-9.
[2] “STRIPS”. dictionary.com - financial dictionary. Re-
trieved 2009-10-30.
[3] 26 U.S.C. § 1273
[4] “Zero Coupon Bonds”. U.S. Securities and Exchanges
Commission. Retrieved 2007-11-17.
3
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