Zero-coupon bond

Definition

A zero-coupon bond is a type of bond that does not pay periodic interest (coupon payments) to the bondholder. Instead, it is sold at a discount to its face value, and the investor receives the face value of the bond when it matures.

What are zero-coupon bonds?

Unlike traditional bonds, zero-coupon bonds do not make regular interest payments to the bondholder. Instead, they are issued at a discount and pay out a lump sum at maturity.

Investors purchase zero-coupon bonds at a price below their face value. The discount represents the interest that would have been paid over the life of a traditional bond. When the bond reaches its maturity date, the issuer pays the bondholder the full face value, which is the amount the bond was originally intended to be worth.

Zero-coupon bonds tend to have less price volatility compared to traditional bonds because they do not make coupon payments, which can be affected by changes in market interest rates. Even though zero-coupon bonds do not make regular interest payments, investors may have to pay taxes on the imputed interest that accrues each year. This is known as “phantom income.”

While zero-coupon bonds offer a fixed return at maturity, there is some risk associated with holding them, particularly if the issuer defaults. Investors should assess the creditworthiness of the issuer before investing. Also, zero-coupon bonds are generally less liquid than other types of bonds since they do not trade as frequently. This means that selling them before maturity may be more challenging.

How are zero-coupon bonds priced?

A zero-coupon bond is priced based on its present value, which is determined by discounting its face value to the present day using an appropriate discount rate.

Since zero-coupon bonds do not pay periodic interest, their value is extracted from the difference between the purchase price and the face value received at maturity. The discount rate used for valuation typically reflects current interest rates and the bond’s risk profile.

Investors consider the time until maturity and current market conditions to assess the bond’s attractiveness relative to other investments with similar risk profiles and durations.

How are zero-coupon bonds taxed?

Zero-coupon bonds are taxed annually on the accrued interest, which is calculated as the difference between the purchase price and the face value at maturity. Although they do not pay regular interest, holders must report and pay taxes on the imputed interest each year, based on the bond’s annual accrual. Upon maturity or sale, any capital gains are subject to capital gains tax, based on the difference between the sale price and the purchase price.

Example of zero-coupon bonds

Imagine you’re an investor interested in purchasing bonds. You come across a zero coupon bond issued by XYZ Corporation, which has a face value of £1,000 and a maturity period of 5 years.

Let’s say the zero coupon bond issued by XYZ Corporation is currently trading at £800 in the market. As an investor, you purchase this bond for £800.

Over the next 5 years, you hold onto the zero coupon bond without receiving any interest payments. At the end of the 5-year maturity period, XYZ Corporation repays the bond’s face value of £1,000 to you.

By purchasing the zero coupon bond at a discounted price of £800 and receiving £1,000 at maturity, you earn a return of £200 over the 5-year period.