Definition: Zero-coupon bond

Category: External debt - IMF

A single-payment security that does not involve interest payments during the life of the bond. 

The bond is sold at a discount from par value, and the full return is paid at maturity. 

The difference between the discounted issue price and the face or redemption value reflects the market rate of interest at the time of issue and time to maturity. 

The longer the maturity of the bond and the higher the interest rate, the greater the discount against the face or redemption value. 

Zero-coupon, and deep-discount bonds, have four particular advantages for investors: 

• There may be some tax advantage in receiving a capital gain rather than an income payment; 
• There is no or little (deep-discount bond) reinvestment risk (the possibility that when coupon payments fall due, and need to be reinvested, interest rates will be lower); 
• The bond has a longer "duration" than a bond of comparable maturity that pays fixed- or variable-rate interest, so making the zero-coupon bond’s price more sensitive to interest rate changes; and 
• A zero-coupon bond is a leveraged investment in that a relatively small initial outlay gives exposure to a larger nominal amount. http://ec.europa.eu/eurostat/ramon/statmanuals/files/external_debt_guide_2003_EN.pdf#page=227