Zero coupon bonds, as the name implies, refer to bonds that are issued at a discount, redeemed at par, and bear no interest. This type of bond does not give interest at any interval. The difference between par value and issued value is the ROI of investors.
The term “coupon” is commonly used in debt markets to refer to interest payments. Thus, a zero-coupon bond translates into a no-interest bond!
Since bonds are exempt from taxation, the interest earned on them is taxed by the federal or local governments. So how are these discount coupons taxed?
Well, the accrued income of zero coupon bonds is called imputed or phantom interest. This is taxed on a yearly basis under the bracket of capital gains tax.
People invest in bonds, not for the benefits of capital growth or wealth accumulation. Instead, bonds are held as umbrella instruments for protecting wealth and managing the financial risk in times of market crash.
Now let’s understand zero-coupon bond pricing.
If the par value of a bond is 10,000, its yielding a 5% lumpsum coupon, and is held for 10 years then the issue price of the bond should be
ISSUE PRICE = Maturity Value/(1+required interest rate)^No. Of years of maturity
= 10,000/(1+0.05)^10
= Rs. 6142
Thus, the profit of the investor is 10,000-6142 = Rs 3851 (The minor differences in value are due to the time value of money.)
Bonds are long-term instruments and all held for maturity above 10 years, some are for more than 20 and even 30 years. These are treasury bonds or T-Bills issued by the government.
The investment amount, maturity time and bond yield are fixed, and this is the reason why they are categorized into fixed income instruments. Since bonds with regular interest payments cannot change their yields due to any change in repo rate so they are not subject to any fluctuations. However, zero coupon bonds have no interest to pay so they are likely to fluctuate on account of changes in federal interest rates.
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