Zero coupon bond

Zero coupon or strip bonds are fixed income securities created from the cash flows that make up a normal bond.

A bond which pays no coupons, and sold at a deep discount to its face value, and matures at its face value. A zero-coupon bond has an important advantage of being free of reinvestment risk, though the downside is there is no opportunity to enjoy the effects of a rise in market interest rates. Also, such bonds tend to be very sensitive to changes in interest rates, since there are no coupon payments to reduce the impact of interest rate changes. In addition, markets for zero-coupon bonds are relatively illiquid. Under USA tax law, the imputed interest on a zero-coupon bond is taxable as it accrues, even though there is no cash flow.

In the fixed income markets, there are a variety of instruments that defer the payment of interest. This article focuses on instruments that have terms greater than a year. See the article discount instruments for shorter-term forms. Generally, the instruments are called deferred-interest bonds (DIBs). They fall into three categories. Accrued-coupon bonds are issued at some par value and have a stated nominal yield. Rather than pay coupons, they accrue them until maturity. Zero-coupon bonds have a par value that is their maturity value. They are issued at a discount from par value. These are also called zeros or original issue discount (OID) bonds. Deferred-coupon bonds pay no coupons for their first few years but then pay a higher coupon than they otherwise would for the remainder of their term. Usually, they are issued below par. If the issuer's credit quality doesn't deteriorate and interest rates don't rise, they trade above par by the time they start paying coupons. They mature for their par value plus the final coupon.

While accrued-coupon and zero-coupon bonds only pay interest at maturity, for accounting and tax purposes, interest is generally recognized as income when it accrues. Treatment of deferred-coupon bonds depends upon the specific structure and jurisdiction. Paradoxically, you will hear of accrued-coupon and zero-coupon bonds being described as safe, conservative investments or risky, speculative investments. It all depends on how you intend to use and account for them. For a buy-and-hold investor who accounts for them on book value, the bonds are a safe investment, so long as the issuer is of good credit quality. They guarantee a specific yield until maturity. Because they do not pay coupons, they pose no reinvestment risk. For investors who sell the bonds prior to maturity or account for them at market value, they can be risky. Their duration equals their time to maturity. Many of these bonds have terms of 20 or 30 years. With durations like that, their market values can be as volatile as those of common stocks. Examples of these types of bonds are municipal accrued-coupon bonds and Treasury zero-coupon bonds.

Conceptually, a zero coupon security is like a Treasury Bill or "T-Bill". The investor pays something up front in exchange for a promise to receive $100 on the maturity date.

Maturity dates on zero coupon bonds are usually long-term—many don’t mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the deep discount, an investor can put up a small amount of money that can grow over many years.

Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the USA Treasury, corporations, and state and local government entities. Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than most types of bonds in the secondary market. In addition, although zero coupon bonds do not pay any interest until maturing, investors may have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying the imputed tax by buying municipal zero coupon bonds

In the USA, the holder may be liable for imputed income (sometimes called phantom income), even though these bonds don't pay periodic interest. Because of this, zero coupon bonds subject to U.S. taxation should generally be held in tax-deferred retirement accounts, to avoid paying taxes on future income. Alternatively, when purchasing a zero coupon bond issued by a USA state or local government entity, the imputed interest is free of USA federal taxes, and in most cases, state and local taxes, too.

In finance, convexity is a measure of the sensitivity of the price of a bond to changes in interest rates. The price sensitivity to parallel IR shifts is highest with a zero-coupon bond, and lowest with an amortizing bond (where the payments are front-loaded). Although the amortizing bond and the zero-coupon bond have different sensitivities at the same maturity, if their final maturities differ so that they have identical bond durations they will have identical sensitivities.

Zero coupon bonds have no "coupon" or periodic interest payments. Instead, the investor receives one payment - at maturity - that is equal to the principal invested plus the interest earned, compounded annually (semi-annually), at a stated yield. The yield to maturity corresponds to the internal rate of return on the bond. Yield curves are one way of reproducing the situation of a bond market in graphic form. Typically, a yield curve would be a graph of the internal rates of return of the bond over the years to maturity.

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