Define zero coupon rate

Zero-Coupon Bond 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. Zero coupon bonds may be long or short term investments.

What is a Coupon

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.

Zero Curve

Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U. Treasury bill market is the most active and liquid debt market in the world.

How it works (Example):

Find out what it means when a bond has a coupon rate of zero and how a bond's coupon rate and par value affect its selling price on the open. What is a Zero-Coupon Bond. A zero-coupon bond is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount.

Zero coupon bonds have a duration equal to the bond's time to maturity, which makes them sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons from the principal of coupon bonds, 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.

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  • Zero Coupon Bond: Definition, Formula & Example |

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 occurs only at maturity.

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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. 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.

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. 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. Alternatively, when purchasing a zero coupon bond issued by a U.

Zero coupon bonds were first introduced in the s, but they did not become popular until the s.

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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 led 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.

Zero-Coupon Bond

The face value is repaid when the bond reaches maturity. So, although no coupon payments are made on zero coupon bonds until maturity, investors may still have to pay federal, state, and local income taxes on the imputed or phantom interest that accrues each year. Zero coupon bonds typically have long maturity periods and can take 10 or more years to pay out. Forwards Options Spot market Swaps. Adjusting Accounts: Homework

In India, the tax on income from deep discount bonds can arise in two ways: interest or capital gains. Meanwhile, if you have specific cash needs at a given time that you don't want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals. Dan Caplinger has been a contract writer for the Motley Fool since As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.

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With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world. Follow DanCaplinger. Premium Services. Stock Advisor Flagship service. Rule Breakers High-growth stocks. View all Motley Fool Services.

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zero-coupon bond

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