What Is a Zero-Coupon Bond
If a bond never pays any interest in between, what would make you buy it? The secret lies in the structure of 'buying cheap and getting the full value back.'
What is a zero-coupon bond
A zero-coupon bond is, as the name says, a bond that pays no interest (coupon) in between.
So how does it produce a return? It's 'issued at a discount' at a price much cheaper than face value, and at maturity you get back the full face value. For example, you buy now for about $518 a bond that pays about $740 ten years later. This difference of about $222 is effectively the interest.
Because there's no interim interest to receive, a feature is that you don't have to worry about where to reinvest interest.
Source: FINRA (One-Minute Guide to Zero Coupon Bonds). Zero-coupon bonds are issued at a discount and redeem the face value at maturity.
The U.S. STRIPS case
One of the most famous zero-coupon bonds is U.S. STRIPS.
STRIPS stands for 'Separate Trading of Registered Interest and Principal Securities.' A dealer takes an ordinary coupon-bearing government bond and 'strips' each coupon (interest) and the principal apart into separate pieces.
For example, if you split a single government bond that pays interest each year and returns principal at maturity into interest pieces and a principal piece, each piece becomes a zero-coupon bond. It's a tool that lets you pick and hold state-guaranteed, safe cash flows for the specific points in time you want.
No cash comes in, but you owe tax: phantom income
The thing to watch most with zero-coupon bonds is tax.
U.S. tax law (the IRS) treats a zero-coupon bond's discount as 'imputed interest' and, under the original issue discount (OID) rule, taxes a little bit of it as interest income each year. The problem is that in reality no cash comes in at all until maturity.
In other words, a situation arises where you owe tax each year even though you have no cash in hand. This is called 'phantom income.' On top of that, this income is taxed as ordinary income, not as a capital gain.
So in the U.S., people sometimes respond by holding them in tax-advantaged accounts or using municipal-bond-type zero-coupon bonds whose interest is tax-exempt.
Source: Nasdaq (How Are Zero Coupon Bonds Taxed?), FINRA. Tax rules differ by country, account, and period, so Korean investors should separately check the domestic taxation method.
Why the price swings so much
A zero-coupon bond pays cash exactly once, at maturity. So its 'duration'—which we'll cover later—equals its maturity. This means it's much more sensitive to rate changes than a coupon bond of the same maturity.
That is, even a small rate rise makes a zero-coupon bond's price fall sharply, and a rate drop makes it rise sharply. If you hold to maturity you receive the set face value, but if you have to sell midway, you can take a larger-than-expected loss.
Remember that 'a bond that looks simple because it pays no interest' is actually one of the most sensitive bonds to rates.
A zero-coupon bond's duration equals its maturity, so its rate sensitivity is high. Even a 'safe government bond piece' can incur a loss if sold before maturity.
Frequently Asked Questions
Q. If it pays no interest, how does it produce a return?
Because you buy below face value and get the full face value back at maturity. For example, if you bought now for about $518 a bond that returns about $740 ten years later, that difference of about $222 is effectively the interest. In place of interim interest, all the return is contained in this discount.
Q. Is phantom income really that important?
Under the U.S. tax method it is. Even though no cash actually comes in, you may have to pay tax as interest income each year, creating the burden of setting aside cash separately to pay it. That said, this is on the U.S. tax basis, and Korea's taxation method may differ, so you should check the domestic tax system separately.
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