A zero-coupon bond is a debt security that does not pay periodic interest but is issued at a discount to its face value and pays the full face value at maturity.
A zero-coupon bond is a type of bond that does not make any interest (coupon) payments during its life. Instead, it is issued at a substantial discount to its par (face) value, and the investor receives the full face value at the bond’s maturity date. The difference between the purchase price and the face value represents the interest earned by the investor. These bonds are sometimes referred to as discount bonds or deep discount bonds because of this issuance at prices below par. In finance and wealth management, zero-coupon bonds are used as instruments for long-term planning due to their predictable payoff at maturity. Since no periodic interest is paid, the investor does not receive cash flows until maturity, which affects the bond’s cash flow profile and taxation. Zero-coupon bonds can be issued by governments, corporations, or municipalities, and are particularly attractive in markets with low interest-rate environments or for investors seeking to lock in a lump sum payment at a future date. Valuing zero-coupon bonds involves discounting the maturity value back to the present using the appropriate yield to maturity. Because these bonds are sensitive to interest rate changes, their prices can be more volatile than regular coupon bonds, especially those with long maturities. In portfolio management, they are often used for liability matching or to fund specific future obligations.
Zero-coupon bonds serve as a strategic component in family office portfolios by offering a known future payoff, which can aid in precise financial planning and liability matching. The lack of periodic interest payments makes them ideal for investing toward specific long-term goals such as wealth transfer, estate planning, or future capital needs, without requiring interim cash for reinvestment or distribution. From a tax perspective, although no interest payments are received annually, holders of zero-coupon bonds must recognize imputed interest income each year, which is taxable despite the absence of cash flow. This feature necessitates careful tax planning within a family office to manage potential tax liabilities effectively. Additionally, zero-coupon bonds can help diversify fixed-income allocations and can be particularly appealing when structuring portfolios to meet future liquidity requirements with minimum reinvestment risk.
For example, a zero-coupon bond with a face value of $10,000 matures in 10 years. It might be issued at $6,139.13. The investor pays $6,139.13 today and receives $10,000 at maturity. The yield to maturity can be calculated as: Yield to Maturity = [(Face Value / Purchase Price)^(1 / Years To Maturity)] - 1 Yield = [(10,000 / 6,139.13)^(1/10)] - 1 ≈ 0.05, or 5% annual yield. This reflects the implied interest earned over 10 years compounded annually with no periodic payments.
Discount Bond
A discount bond is a bond trading below its par value, often due to lower interest rates or credit concerns. Zero-coupon bonds are a specific form of discount bond since they are issued and sold at a discount and mature at par, but not all discount bonds are zero-coupon bonds, as some pay periodic interest.
Do zero-coupon bonds pay any interim interest payments?
No, zero-coupon bonds do not pay any periodic or interim interest payments. Instead, they are sold at a discount and pay their full face value only at maturity.
How are zero-coupon bonds taxed if they do not pay interest annually?
Although zero-coupon bonds do not pay interest annually, investors must pay tax on the imputed interest income each year as if they had received the interest, which can create taxable income without cash distributions.
Are zero-coupon bonds riskier than regular coupon bonds?
Zero-coupon bonds tend to be more sensitive to interest rate changes than regular coupon bonds, making them potentially more volatile, especially for long maturities, which can increase their risk profile.
