Zero-Coupon Bond
A bond that pays no periodic interest; instead it is issued at a deep discount to face value and redeems at par on maturity. The investor's entire return is the difference between the purchase price and the redemption amount.
Definition
A zero-coupon bond (ZCB) pays no periodic coupon. It is issued (or traded) at a price significantly below its face value, with the investor receiving the full face value at maturity. The return is entirely in the form of price appreciation from the discounted purchase price to par. The price of a ZCB is:
P = F / (1 + y)^n
where F is face value, y is the annual YTM (yield to maturity), and n is years to maturity. Because there are no intermediate cash flows, Macaulay Duration of a ZCB equals its maturity exactly — making ZCBs the purest expression of duration risk. In India, ZCBs include: (a) RBI-issued T-Bills (91-day, 182-day, 364-day) — the most liquid short-end ZCBs; (b) G-Sec STRIPS (Separate Trading of Registered Interest and Principal Securities) — long-dated ZCBs created by stripping coupon G-Secs; and (c) Deep Discount Bonds (DDB) — corporate zero-coupon paper issued by entities like REC, PFC, NABARD.
How it is computed
The YTM of a ZCB is simply solved as:
y = (F/P)^(1/n) − 1
For T-Bills (maturity ≤ 1 year), Indian convention uses a simple-interest discount yield:
Discount Yield = [(F − P) / F] × (365 / Days to Maturity)
and a separate bond equivalent yield for comparison with coupon bonds. For STRIPS and DDBs with tenor > 1 year, compound annual yield is used. Accreted interest (the notional coupon in each period) must be computed annually for tax purposes even though no cash is paid — this is called original issue discount (OID) treatment under the Income-tax Act.
Why it matters for investors
ZCBs offer properties no coupon bond can match: (1) Reinvestment risk elimination: Since there are no interim coupons, the YTM at purchase is the locked-in realised return — no assumption about reinvestment rates needed. This makes ZCBs ideal for goal-based investing where a specific sum is needed at a specific future date (e.g., a child's education fund in 10 years). (2) Maximum duration: A 10-year ZCB has MD ≈ 10 / 1.075 ≈ 9.3 years — the highest possible duration for any 10-year instrument. This amplifies both gains (in falling-rate environments) and losses (in rising-rate environments). (3) G-Sec STRIPS for liability matching: Insurance companies and pension funds use STRIPS to precisely match long-dated liabilities without coupon reinvestment mismatch. SEBI and IRDAI permit STRIPS as eligible investments for regulated entities.
Worked example
An investor buys a 10-year GoI G-Sec STRIP with face value ₹1,00,000 at a YTM of 7.30%:
Purchase price = ₹1,00,000 / (1.073)^10 = ₹1,00,000 / 2.0205 = ₹49,492
The investor pays ₹49,492 today and receives ₹1,00,000 in 10 years — a nominal gain of ₹50,508. No coupon payments occur in between. Macaulay Duration = 10 years exactly; Modified Duration = 10 / 1.073 = 9.32 years. If yields rise 100 bps immediately after purchase, the bond's price falls approximately 9.32% to ~₹44,878 — a mark-to-market loss of ₹4,614, though the ultimate maturity repayment remains ₹1,00,000.
Caveats
Tax on accreted interest: Under Indian tax law, OID (original issue discount) may be treated as interest income in the year of accrual even though no cash is received — consult a tax adviser before investing in DDBs in taxable accounts. Mark-to-market volatility: Due to maximum duration, ZCBs exhibit the largest price swings of any fixed-maturity bond — not suitable for investors with short investment horizons relative to maturity. Liquidity: STRIPS are less liquid than on-the-run coupon G-Secs; bid-ask spreads can be wide. STRIPS creation/reconstitution: Only Primary Dealers (RBI-licensed) can create and reconstitute STRIPS under the RBI STRIPS Guidelines 2010.
See also
Primary source
- RBI STRIPS Guidelines 2010: rbi.org.in — STRIPS Guidelines
- RBI T-Bill auction results: rbi.org.in
- Income-tax Act §2(28A) (interest definition including OID), Finance Act 2023 §50AA
MintByte is registered with AMFI (ARN-314872) and APMI (APRN-01658). This glossary entry is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any security.