A zero-coupon bond

A zero-coupon bond is a type of bond that does not pay periodic interest (coupon) payments to bondholders during its term. Instead, zero-coupon bonds are sold at a discount to their face value (par value or principal) and mature at their full face value. The return on investment for zero-coupon bonds is derived from the difference between the purchase price and the face value of the bond at maturity.

Here are some key features of zero-coupon bonds:

1. Issuance: Zero-coupon bonds are typically issued by governments, municipalities, corporations, and other entities to raise capital for various purposes, such as financing infrastructure projects, funding long-term liabilities, or restructuring existing debt.

2. Maturity: Zero-coupon bonds have fixed maturities, ranging from a few months to several decades. At maturity, the bondholder receives the full face value of the bond, representing the return of the principal investment.

3. Coupon Payments: Unlike traditional bonds, zero-coupon bonds do not make periodic interest payments to bondholders. Instead, the interest income is accrued and compounded over the life of the bond, resulting in a higher effective yield for investors.

4. Discount Pricing: Zero-coupon bonds are sold at a discount to their face value, meaning that investors pay less than the face value of the bond when they purchase it. The discount represents the interest income that will be earned by the investor over the life of the bond.

5. Yield: The yield on a zero-coupon bond is calculated based on the difference between the purchase price and the face value of the bond, expressed as a percentage of the face value. Because zero-coupon bonds do not pay periodic interest payments, their yield is typically higher than that of traditional bonds with similar maturities.

6. Taxation: Although zero-coupon bonds do not pay periodic interest payments, investors are still required to report and pay taxes on the imputed interest income each year, even though they do not receive cash payments until maturity. This taxation treatment can result in tax liabilities for investors, even if they have not yet received any cash payments from the bond.

Zero-coupon bonds are favoured by investors seeking long-term capital appreciation, predictable cash flows, and portfolio diversification. They are commonly used in retirement planning, education savings, and estate planning strategies, as well as by institutional investors, pension funds, and insurance companies to match long-term liabilities with long-term assets.