Zero coupon bond
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Zero coupon bonds are bonds which do not pay periodic interest payments, or so-called "coupons". Zero coupon bonds are purchased at a discount from their value at maturity. The holder of a zero coupon bond is entitled to receive a single payment, usually of a specified sum of money at a specified time in the future. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond.
In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.
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 bond generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.
[edit] Strip bonds
Investment bankers or dealers may separate the coupons from the bond principal, which is known as the residue, so that different investors may receive the principal and each of the coupon payments. This creates a supply of new zero coupon bonds.
The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds. "STRIPS" stands for Separate Trading of Registered Interest and Principal Securities.
Dealers normally purchase a block of high-quality and non-callable bonds—often government issues—to create strip bonds. A strip bond has no reinvestment risk because the payment to the investor only occurs at maturity.
The impact of interest rate fluctuations on strip bonds, known as the bond duration, is higher than for a coupon bond. A zero coupon bond always has a duration equal to its maturity, a coupon bond always has a lower duration. Strip bonds are normally available from investment dealers maturing at terms up to 30 years. For some Canadian bonds the maturity may be over 90 years.
In Canada, investors may purchase packages of strip bonds, so that the cash flows are tailored to meet their needs in a single security. These packages may consist of a combination of interest (coupon) and/or principal strips.
In New Zealand, bonds are stripped first into two pieces—the coupons and the principal. The coupons may be traded as a unit or further subdivided into the individual payment dates.
In most countries, strip bonds are primarily administered by a central bank or central securities depository. An alternative form is to use a custodian bank or trust company to hold the underlying security and a transfer agent/registrar to track ownership in the strip bonds and to administer the program. Physically created strip bonds (where the coupons are physically clipped and then traded separately) were created in the early days of stripping in Canada and the U.S., but have virtually disappeared due to the high costs and risks associated with them.
[edit] Uses
Pension funds and insurance companies like to own long maturity zero coupon bonds because of the bonds' high duration. This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate, and therefore offset, or immunize the interest rate risk of these firms' long-term liabilities.
Yield curve traders and academics use zero coupon bonds to precisely analyze the yield curve. Coupon bonds inherently mix different cash flows and interest rates, but by limiting cash flows to a single payment, zero coupon bonds enable analysts to separate out the effect of a single interest rate for each time period.
[edit] Taxes
In the United States, the holder may be liable for imputed income (sometimes called phantom income), even though these bonds don't pay periodic interest [1]. 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 U.S. state or local government entity, the imputed interest is free of U.S. federal taxes, and in most cases, state and local taxes, too.
Zero coupon bonds were first introduced in 1960s, but they did not become popular until the 1980s. The use of these instruments was aided by an anomaly in the US tax system, which allowed for deduction of the discount on bonds relative to their par value. This rule ignored the compounding of interest, and lead to significant tax-savings when the interest is high or the security has long maturity. Although the tax loopholes were closed quickly, the bonds themselves are desirable because of their simplicity.
