Zero-coupon bonds, also known as discount bonds or pure discount bonds, are a type of fixed-income security that do not make periodic interest payments, or coupon payments, like traditional bonds. Instead, they are issued at a discount from their face value and mature at par (face value), with the difference between the purchase price and the face value representing the investor’s return.
Key Features
- No Periodic Interest Payments: Zero-coupon bonds do not make interim interest payments.
- Issued at a Discount: They are sold for less than their face value.
- Mature at Par: At maturity, the bondholder receives the face value of the bond.
- Imputed Interest: The difference between the purchase price and the face value is considered imputed interest, which accrues over the life of the bond.
Types of Zero-coupon Bonds
Government Zero-coupon Bonds
These are issued by the government and are usually considered a low-risk investment. They include instruments like U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities).
Corporate Zero-coupon Bonds
Issued by corporations, these bonds tend to offer higher yields than government bonds due to the higher risk associated with corporate issuers.
Municipal Zero-coupon Bonds
These are issued by state and local governments or agencies, often providing tax-exempt status on the imputed interest, which can be particularly advantageous for certain investors.
Historical Context
The concept of zero-coupon bonds dates back to the early 20th century, but they gained significant popularity in the 1980s when the U.S. Treasury introduced STRIPS. These securities allowed investors to hold and trade the principal and interest components of eligible Treasury notes and bonds as separate securities.
Investment Strategies
Buy and Hold
Investors who use this strategy purchase zero-coupon bonds and hold them until maturity, ensuring they receive the face value.
Ladder Strategy
Investing in zero-coupon bonds with varying maturities to manage interest rate risk and liquidity.
Tax Considerations
Zero-coupon bonds are subject to original issue discount (OID) rules, which require investors to report a portion of the imputed interest income each year, even though they do not receive periodic interest payments. This can lead to a situation where investors owe taxes on income they have not yet received, known as “phantom income.”
Comparisons with Other Bonds
Traditional Bonds
Traditional bonds pay periodic interest (coupons), whereas zero-coupon bonds do not, making the latter more sensitive to interest rate changes.
Floating-rate Bonds
Floating-rate bonds have variable interest payments, unlike the fixed, imputed interest of zero-coupon bonds.
Related Terms
- Yield to Maturity (YTM): The total expected return if the bond is held until maturity.
- Duration: A measure of a bond’s sensitivity to interest rate changes.
- Coupon Bond: A bond that makes periodic interest payments.
- Treasury STRIPS: Separate Trading of Registered Interest and Principal of Securities, a type of zero-coupon bond issued by the U.S. Treasury.
FAQs
How is the return on a zero-coupon bond calculated?
Are zero-coupon bonds riskier than regular bonds?
Can zero-coupon bonds be sold before maturity?
References
- Fabozzi, Frank J. “Bond Markets, Analysis and Strategies.” Pearson Education.
- Securities Industry and Financial Markets Association (SIFMA). “Introduction to Fixed Income Securities.”
Summary
Zero-coupon bonds are a unique investment vehicle offering no periodic interest payments but instead are sold at a discount and mature at face value. They come in various forms, including government, corporate, and municipal bonds, each suited for different types of investors. Understanding their tax implications, investment strategies, and sensitivity to interest rate changes is crucial for making informed investment decisions.
