Zero coupon bond
Encyclopedia
A zero-coupon 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. When the bond reaches maturity, its investor receives its par
(or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds, and any type of coupon bond that has been stripped of its coupons.
In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.
Some zero coupon bonds are inflation indexed
, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power
rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value
of the bond.
Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond market
s. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.
The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds. "STRIPS" stands for SSeparate TTrading of Rregistered Interest and Principal Securities.
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.
s 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.
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 15 February 2002.
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
bought at a price lower than its face value
Face value
The Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...
, with the face value repaid at the time of maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
. It does not make periodic interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
payments, or have so-called "coupons," hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par
Par value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
(or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds, and any type of coupon bond that has been stripped of its coupons.
In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.
Some zero coupon bonds are inflation indexed
Inflation-indexed bond
Inflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780...
, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value
Face value
The Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...
of the bond.
Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond market
Secondary market
The page applies to the finanical term; For the merchandising concept, see Aftermarket .The secondary market, also called aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold....
s. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.
Strip bonds
Zero coupon bonds have a duration equal to the bond's time to maturity, which makes them sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons from the principal of coupon bonds, which is known as the residue, so that different investors may receive the principal and each of the coupon payments. This creates a supply of new zero coupon bonds.The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds. "STRIPS" stands for SSeparate TTrading of Rregistered Interest and Principal Securities.
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
Bond duration
In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
, 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
Canada
Canada is a North American country consisting of ten provinces and three territories. Located in the northern part of the continent, it extends from the Atlantic Ocean in the east to the Pacific Ocean in the west, and northward into the Arctic Ocean...
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
New Zealand
New Zealand is an island country in the south-western Pacific Ocean comprising two main landmasses and numerous smaller islands. The country is situated some east of Australia across the Tasman Sea, and roughly south of the Pacific island nations of New Caledonia, Fiji, and Tonga...
, 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
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
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.
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, but have virtually disappeared due to the high costs and risks associated with them.
Uses
Pension fundPension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
s and insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
companies like to own long maturity zero-coupon bonds because of the bonds' high duration
Bond duration
In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
. This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate, and therefore offset, or immunize
Immunization (finance)
In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...
the interest rate risk of these firms' long-term liabilities.
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 15 February 2002.