Zero coupon bond are issued at lower price than its face value and the principal value is repaid to the holders on the time maturity of bonds. Zero coupon bonds are also known as discount bonds or accrual bond as these are purchased at a large discount on the face value. It does not make periodic interest(coupon) payments to the bondholders and hence, there are no cash inflows. The holder of a zero-coupon bond only receives the face value of the bond at maturity which itself acts as interest to holders. Bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa. Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities.
General characteristics of zero coupon bonds:
- Issued at deep discount and redeemed at full face value
- You must pay tax on interest annually even though you don’t receive it until maturity
- Zero coupon bonds are more volatile than regular bonds