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Zero Coupon Bonds

See Also:
What is a Bond
Non-Investment Grade Bonds
Covenant Definition of a Bond Contract
Yield to Maturity of a Bond
Financial Instruments

Zero-Coupon Bonds¶

A zero coupon bond is a debt security that does not have periodic interest payments. The bond is issued at a deep discount from par value, to compensate for the lack of interest payments, and then redeemed at par value at maturity.

Stripped Bond

Strip bonds are synthetic zero-coupon bonds created by banks or dealers. The principal amount (the corpus) is separated from the interest payments (the coupon payments) and the two parts are sold separately to investors. This creates zero-coupon bonds. The investors then receive a lump sum at the maturity date, equal to the value of corpus or the coupon payments, depending on their contract. The contracts are known as STRIPS (Separate Trading of Registered Interest and Principal of Securities).

Imputed Interest

According to the IRS, the holder of a zero-coupon bond owes income tax on the bond’s imputed interest. Imputed interest refers to the implied periodic interest payments that the bondholder does not actually receive until maturity. Imputed interest on zero-coupon bonds issued by municipalities is tax exempt.