Zero-coupon bond (also discount bond or deep discount bond) is a bond bought or issued at a price lower than its face value and the face value repaid at the time of maturity. It does not make periodic interest (coupon) payments. Hence the term is called as zero-coupon bond. When the bond reaches maturity, its investors receive its par (or face) value.
Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds and any other type of coupon bond that has been stripped of its coupons.
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 are sold at a substantial discount from the face amount. For example, a bond with a face amount of Rs. 1,00,000/- maturing in 20 years with a 5.5% coupon, may be purchased for roughly Rs. 33,785/- only. At the end of the 20 years, the investor will receive Rs. 1,00,000/-. The difference between Rs. 1,00,000/- and Rs. 33,785/- represents the interest that compounds automatically until 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 bonds 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.
In India, the tax on income from deep discount bonds can arise in two ways, interest or capital gains. It is also law that interest has to be shown on accrual basis for deep discount bonds issued after February 2002. This is as per CBDT circular No 2 of 2002 dated 15 February 2002.