Financial Terms / zero coupon bond

Zero-Coupon Bond Basics

A zero-coupon bond is a bond that is issued without interest payments and trades at a much lower price than its face value.

What is a zero-coupon bond?

A zero-coupon bond is a bond that does not pay out any periodic interest payments, but instead is sold at a discount from its face value and matures at its face value.

How is a zero-coupon bond structured?

A zero-coupon bond is structured so that the issuer pays the bondholder the face value when the bond matures. The bondholder pays an amount lower than the face value when purchasing the bond, the difference being the return earned on the bond.

Are there any risks associated with zero-coupon bonds?

There are risks associated with zero-coupon bonds, such as the risk of default, interest rate risk, inflation risk, and liquidity risk.

Are there any tax implications of owning a zero-coupon bond?

Yes. The Internal Revenue Service considers the difference between the purchase price of a zero-coupon bond and the face value of the bond to be taxable income. This income is taxed at the same rate as ordinary income.

Key Points

Zero-coupon bond does not pay interest
A zero-coupon bond does not pay out any interest payments throughout its lifetime. Instead, the bond is issued at a deep discount to its face value and the investor receives the face value at maturity.
Trades at a deep discount
A zero-coupon bond typically trades at a deep discount relative to its face value, meaning that the investor pays less than the face value of the bond when buying it. This discount reflects the fact that the investor will not receive any interest payments from the bond.
Often issued from the start
Zero-coupon bonds are often issued from the start and do not need to be stripped from other bonds. This makes them a convenient way for issuers to raise funds quickly, without having to wait for interest payments.
Price can be calculated using equation
The price of a zero-coupon bond can be calculated using an equation that takes into account the face value of the bond, the time to maturity, and the market rate of interest. This equation allows investors to determine how much they need to pay for a zero-coupon bond in order to receive the face value at maturity.

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