Context:
Zero-Coupon Bonds (ZCBs), or deep-discount bonds, are fixed-income instruments issued at a discount and redeemed at face value. Popular among HNIs and family offices for their tax efficiency and lump-sum maturity payout, ZCBs saw high demand in late 2024. However, recent monetary and market developments have weakened investor interest.
What Is a Zero-Coupon Bond?
A Zero-Coupon Bond (ZCB) is a type of debt security that does not pay periodic interest (coupons). Instead, it is sold at a deep discount and redeemed at full face value (par value) upon maturity. The investor’s return is the difference between the purchase price and maturity value.
Also known as: Accrual Bond
Key Features of Zero-Coupon Bonds:
- No periodic interest payments (coupons)
- Issued at a discount, repaid at full face value at maturity
- Return = Par Value – Purchase Price
- Subject to interest rate risk if sold before maturity
- Longer maturity = deeper discount = more price volatility
Who Issues ZCBs?
- Government entities
- Corporations
- Financial institutions (which may strip coupons and repackage bonds)
How Zero-Coupon Bonds Work:
- Investor buys a ZCB at a low price (e.g., â‚ą6,855)
- At maturity, the investor receives full face value (e.g., â‚ą20,000)
- The implied yield (e.g., 5.5%) is compounded semiannually
- No interim payments; interest is “imputed” or “phantom” interest
Pricing Formula:
Where:
- M = Maturity Value (Face Value)
- r = Required Interest Rate (Yield)
- n = Years to Maturity
Taxation of Zero-Coupon Bonds:
- Imputed interest is taxable annually, even though no cash is received until maturity
- Taxed as ordinary income, not capital gains
- Known as “phantom interest”
- Ways to avoid tax:
- Buy municipal zero-coupon bonds (often tax-exempt)
- Hold in tax-deferred or tax-exempt accounts (e.g., retirement funds)
- Invest in tax-exempt corporate ZCBs
Advantages of ZCBs:
- Predictable lump-sum payout at maturity
- No reinvestment risk (unlike coupon-bearing bonds)
- Useful for long-term goals (e.g., education, retirement)
- Higher price sensitivity provides opportunities in falling interest rate scenarios
Disadvantages:
- No interim income
- Higher duration and price volatility
- Taxation on imputed interest
- Limited liquidity in secondary markets
Zero-Coupon Bond vs. Regular Bond:
| Feature | Zero-Coupon Bond | Regular (Coupon) Bond |
|---|---|---|
| Interest Payment | None (imputed, not paid) | Paid periodically (semiannual/annual) |
| Purchase Price | Deep discount to face value | Close to face value |
| Return | At maturity (par – purchase price) | Coupons + principal at maturity |
| Price Volatility | Higher | Lower |
| Tax on Interest | On imputed interest annually | On actual coupons received |
