Zero-Coupon Bonds

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., ₹6,855)
• At maturity, the investor receives full face value (e.g., ₹20,000)
• 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: