Zero-Coupon Bond

Bonds are financial instruments that permit investors to earn money by lending money to a government or corporation for a set period of time. Commonly, bond issuers (governments and corporations) reward bondholders (investors) with interest payments called "coupons" throughout the span of a bond's term before returning the principal amount, or "face value," of the bond to the holder once the bond matures.
With regards to interest-paying bonds, an investor's profit — assuming they hold the bond for the entirety of its term and don't resell it — is the total value of the coupon payments they receive throughout a bond's term. So what, then, is a zero-coupon bond, and how do investors bring in money with them?

What Are Zero-Coupon Bonds and How Do They Work?

Like standard bonds, zero-coupon bonds are financial securities that mature after some time, and their face (par) value is paid to their holder toward the finish of their term. Dissimilar to coupon-paying bonds, in any case, zero-coupon bonds don't give periodic coupon payments — thus the name.
Since they don't offer interest payments, these bonds are sold at a discount to boost investors to purchase them. Hence, they are at times alluded to as "deep discount" bonds. The difference between a zero-coupon bond's discounted purchase price and its face value is its investor's profit.

What Is Imputed Interest?

This difference between a zero-coupon bond's purchase price and its face value (the investor's profit in the event that they hold to term) is frequently alluded to as imputed interest. Impute means "to assign or credit to," so imputed interest basically means "suggested interest credited to a bond in spite of a lack of real interest payments."
In this way, where a normal bond's yield is the total value of its interest payments, a zero-coupon bond's all's yield is its imputed interest, or the amount by which its face value was discounted when it was sold.

How Do Zero-Coupon Bonds Differ From Regular Bonds?

Not at all like traditional bonds, zero-coupon bonds are not fixed-income debt instruments. While normal bondholders receive interest payments consistently (generally two times per year or yearly), zero-coupon bondholders never receive interest payments. All things being equal, they receive a single lump sum of cash upon the bond's maturity (or sale, in the event that they sell it before it matures).
Furthermore, zero-coupon bonds are more unpredictable than traditional bonds. This means that their value tends to goes up more than the value of common bonds when interest rates drop (and vice versa)

How Are Zero-Coupon Bonds Priced?

The more drawn out the time until a bond matures, the less secure it is, so generally, bonds with longer terms sell at more extreme discounts (i.e., have higher yields). Ordinarily, the accompanying formula is utilized to compute the sale price of a zero-coupon bond in light of its face value and maturity date.

Zero-Coupon Bond Price Formula

Sale Price = FV/(1 + IR) ^N

Where:

• FV is the face value of the bond.
• IR is the imputed interest rate (communicated as a decimal).
• N is the number of years until the bond matures.

Zero-Coupon Bond Pricing Example

To make 5% imputed interest on a zero-coupon bond with a face value of $15,000 that matures in four years, what amount might they want to pay?

Sale Price = FV/(1 + IR) ^NSale Price = $15,000/(1 + 0.05) ⁴Sale Price = $15,000/(1.05) ⁴Sale Price = $15,000/(1.05) ⁴Sale Price = $15,000/(1.05) ⁴Sale Price = $12,295.08

Thus, in this scenario, an investor would pay $12,295.08 today in exchange for $15,000 in four years.

How Is the Income From a Zero-Coupon Bond Taxed?

In spite of the way that zero-coupon bonds don't really pay interest, bondholders are as yet subject to any applicable taxes on their imputed interest every year. This means that they must pay taxes on income they won't receive until their bond matures.
For example, in the event that a zero-coupon bond was sold at a $100 discount and matures in four years, its holder would need to pay the applicable bond interest tax rate on $25 worth of the bond's total $100 yield every year.
Contingent upon the issuer of a bond and where it is purchased, its imputed interest payments could possibly be taxable at federal, state, and neighborhood levels. In some cases, these taxes can be deferred on the off chance that a bond is purchased through a tax-deferred retirement account like an IRA or 401K. Since numerous people have lower income once retired, they might fall into a lower income tax bracket, so conceding taxes with a retirement account can assist with limiting the effect of taxes on bond yield.

Where Can You Buy Zero-Coupon Bonds?

Zero-coupon bonds, as different bonds, can be purchased directly from the governments and corporations that issue them, through banks or brokers, or on secondary markets.

Features

• Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity.
• A zero-coupon bond is a debt security instrument that doesn't pay interest.
• The difference between the purchase price of a zero-coupon bond and the par value demonstrates the investor's return.

FAQ

How Does a Zero-Coupon Bond Differ From a Regular Bond?

Payment of interest, or coupons, is the key differentiator between a zero-coupon and normal bond. Normal bonds, which are additionally called coupon bonds, pay interest over the life of the bond and furthermore repay the principal at maturity. A zero-coupon bond doesn't pay interest however rather trades at a deep discount, giving the investor a profit at maturity when they reclaim the bond for its full face value.

How Does an Investor Price a Zero-Coupon Bond?

An investor picks the zero-coupon bond they might want to purchase in light of several criteria, yet one of the primary ones will be the imputed interest rate that they can earn at maturity. The price of a zero-coupon bond can be calculated with the accompanying equation:Zero-coupon bond price = Maturity value \u00f7 (1 + required interest rate)^number years to maturity

How Does the IRS Tax Zero-Coupon Bonds?

Imputed interest, once in a while alluded to as "ghost interest," is an estimated interest rate. The imputed interest on the bond is subject to income tax. The IRS utilizes an accretive method while working out the imputed interest on Treasury bonds and has applicable federal rates that set a base interest rate corresponding to imputed interest and original issue discount rules.