Zero-Coupon Bond

A zero-coupon bond is a term referred to the bond with no interest payment. In this case, the investor receives income due to the fact that the bond is purchased cheaper than the face value due at maturity of the bond.

Zero-Coupon Bond explained

Zero-coupon bonds can be issued for any period of time, but are most commonly used for relatively short terms (3-6 month).

In addition to the tax features (associated with the fact that there is no interest income in the form of coupon payments), zero-coupon bonds have another important advantage for the investor. The duration of a bond is exactly equal to its term to maturity, and the dependence of the value on changes in market interest rates also looks simple. As a result, planning the characteristics of an investment portfolio is simplified.

The price of a zero-coupon bond is normally calculated as follows:

STRIPS

The convenience of working with zero-coupon bonds led to the emergence of special derivatives called STRIPS. These bonds are arranged as follows. Dealers purchase reliable long-term bonds - usually multi-year government bonds with coupon payments every 6 months or every year. They then issue securities that entitle them to receive each individual payment on those bonds. So instead of, for example, a ten-year bond with coupon payments every 6 months, you get 20 zero-coupon bonds of varying maturities.

STRIPS are very useful to an investor who would like to buy a bond with a precise term and a simple dependence on interest rates. Suppose an investor is to make a payment on his own obligations in 6.5 years and would like to invest in advance the funds from which that payment will be made. Finding a bond on the market for exactly that term can be difficult, but STRIPS offers a very large selection and helps the investor invest exactly on the terms required.

Taxation of Zero-Coupon Bond

Zero-coupon bonds provide the investor with income in the form of capital gain. This creates two differences in the tax treatment of such bonds:

The payment of taxes is in most cases deferred until the bond matures because the investor does not receive coupon payments, but only accrues a yield when the fair purchase price is determined.

The tax rate (capital gain tax) may differ from the rates applicable to interest income.

Profitability of Zero-Coupon Bond

Yield of the investor of the zero-coupon bond normally forms by the difference between the price it was bought for and its sale price. That said, the lack of coupons does not mean that a zero-coupon bond will be less profitable than a regular bond. The fact is that it is priced below its nominal value. For example, the nominal value of the bond is $100, but the bond is offered at a 20 percent discount. The result is that the investor buys it for $80 and gets $100 when he redeems it. In total the investor will earn $20. Because of the discounted placement, such bonds are also called discount bonds.

As a rule, an exchange-traded zero-coupon bond can be sold on the market at any time, provided there is demand. However, it should be noted that the closer the maturity date, the lower the discount. The price of a discounted bond also depends on the market's assessment of the issuer's creditworthiness and the movement of yields in the market.