Zerocoupon Bond

A zero-coupon bond, also known as a discount bond or deep discount bond, is a debt instrument sold at a price significantly below its face value and redeemed at full par value upon maturity. Unlike conventional coupon-bearing bonds, it does not provide periodic interest payments. Instead, the investor’s return arises entirely from the difference between the purchase price and the amount received at maturity. Zero-coupon structures are used by governments, corporations, and financial institutions to raise funds efficiently while offering investors predictable, single-payment cash flows.

Characteristics and Structure

Zero-coupon bonds differ from standard bonds in that they offer no interim coupons. At issuance, they are priced at a deep discount to compensate investors for the absence of periodic income. Upon maturity, the bondholder receives the stated face value, thereby realising the accumulated interest implicitly contained within the discount.
These instruments may be issued directly as zero-coupon securities or created by separating the coupons and principal components of existing coupon bonds. Such stripped instruments behave like stand-alone zero-coupon bonds, each representing a single cash flow. They can be short-term or long-term: short-term versions, commonly known as bills, often mature in under one year, while long-term variants may extend over several decades. The United States Treasury bill market, for instance, is among the world’s most liquid and is a frequent source of short-term zero-coupon securities.
Some zero-coupon bonds are inflation-indexed. In these cases, the redemption value adjusts to preserve purchasing power, although the majority simply return a fixed nominal amount at maturity.

Duration and Interest Rate Sensitivity

A defining feature of zero-coupon bonds is that their duration is equal to their maturity. As duration measures the sensitivity of a bond’s price to interest-rate changes, zero-coupon bonds are highly responsive to fluctuations in yield levels. In contrast, coupon-bearing bonds have shorter durations relative to their maturity because interim coupon payments reduce their interest-rate exposure.
The lack of reinvestment risk is an advantage: because zero-coupon instruments pay no coupons, investors face no uncertainty regarding the reinvestment rate of interim cash flows. However, their heightened duration means that price volatility can be substantially greater than for comparable coupon bonds.

Stripping and Strip Bonds

Investment banks and dealers frequently create zero-coupon bonds by stripping the individual coupon payments and principal repayment from existing coupon-bearing government or high-quality corporate bonds. Each component can then be sold independently as a separate security, paying a single lump sum on its respective due date.
This process, known as stripping, produces strip bonds. In some jurisdictions, such as Canada and New Zealand, strips may be further packaged or subdivided to tailor cash-flow profiles to investor needs. Maturities for strip bonds can extend for decades, with some Canadian government strips reaching beyond 90 years. Administration typically falls under central banks or central securities depositories, while earlier physical methods of clipping coupons have almost entirely disappeared due to cost and operational risks.
Strip bonds remain attractive for long-term investors seeking precise cash-flow matching, such as in asset–liability management strategies.

Uses and Institutional Demand

Long-dated zero-coupon bonds are especially valued by pension funds and insurance companies. These institutions manage long-term liabilities that are sensitive to interest-rate movements and often employ zero-coupon securities to immunise their portfolios. The high duration of such instruments makes them effective tools for offsetting liability-side interest-rate risk.
Individual investors may use zero-coupon bonds for long-term savings goals, including education funding or retirement planning, because of their predictable payout and the absence of reinvestment uncertainty. Short-term versions are used for liquidity management and low-risk parking of funds.

Taxation Considerations

Tax treatment varies significantly by jurisdiction. In the United States, zero-coupon bonds are typically issued with original issue discount (OID). Even though these bonds pay no periodic interest, the tax code imputes annual income—sometimes termed phantom income—reflecting the accruing discount. As a result, investors may owe tax each year despite receiving no cash until maturity. Consequently, these instruments are often held in tax-advantaged accounts to avoid annual tax liabilities.
Zero-coupon bonds issued by US state or local governments may carry tax-exempt status, rendering their imputed interest free from federal, and often state and local, taxation.
In India, income from deep discount bonds may be classified either as interest or as capital gains, depending on how long the instrument is held. Since February 2002, interest must be recognised on an accrual basis for certain issues in accordance with regulatory guidance.

Historical Development

Although zero-coupon bonds first appeared in the 1960s, their widespread popularity emerged during the 1980s. A temporary anomaly in US tax rules allowed investors to deduct the discount between purchase price and par value without accounting for compounding, making zero-coupon structures particularly tax-efficient during periods of high interest rates or long maturities. Although the loophole was soon closed, the market for zero-coupon bonds remained well established due to their transparency, simplicity, and flexibility in financial planning.

Practical Considerations and Market Relevance

Zero-coupon bonds remain integral to modern financial markets because they offer precise single-cash-flow structures useful for valuation, hedging, and yield-curve construction. Traders employ these instruments to isolate pure interest-rate exposure, and analysts rely on their prices to derive risk-free discount factors.
In many countries, strip programmes continue to support investor demand for long-term, predictable, and easily tradable instruments. Their role in liability matching, portfolio duration management, and fixed-income strategies ensures that zero-coupon bonds maintain a distinct place within both retail and institutional investment portfolios.