A bond that pays no periodic interest, issued at a discount to face value and redeemed at par, with the return coming entirely from the price appreciation.
A zero coupon bond is a debt instrument that does not pay any periodic interest (coupon). Instead, it is issued at a significant discount to its face value and redeemed at par (full face value) at maturity. The difference between the discounted purchase price and the face value at maturity represents the investor's return — a form of imputed interest earned through price appreciation.
For example, a 10-year zero coupon bond with a face value of INR 1,000 might be issued at INR 500. The investor pays INR 500 today and receives INR 1,000 at maturity — no interest payments in between. The annualised yield is approximately 7.2%. This structure eliminates reinvestment risk (the risk that coupon payments cannot be reinvested at the same rate) because there are no intermediate cash flows.
In India, Treasury Bills are the most common form of zero coupon instruments — 91-day, 182-day, and 364-day T-Bills are all issued at a discount and redeemed at par. The RBI also occasionally issues long-term zero coupon government securities. Some corporate bonds and infrastructure bonds are structured as zero coupon instruments. STRIPS (Separate Trading of Registered Interest and Principal of Securities) — where coupon bonds are decomposed into individual zero coupon components — have been introduced by the RBI to develop the market.
Zero coupon bonds have the highest duration (interest rate sensitivity) among bonds of equal maturity because all cash flow is concentrated at maturity. A 10-year zero coupon bond is approximately twice as sensitive to interest rate changes as a 10-year coupon-paying bond. This makes them powerful tools for both speculation on rate changes and for liability matching — pension funds use long-duration zero coupon bonds to match specific future payment obligations.
Tax treatment of zero coupon bonds in India is governed by Section 2(48) of the Income Tax Act, which specifically defines them. The discount is treated as interest income, accruing proportionally over the holding period. If sold before maturity, the accrued portion is taxable. For listed zero coupon bonds held over 12 months, capital gains treatment may apply to the appreciation beyond the accrued interest component.
Formula
Price = Face Value / (1 + r)^n (where r = yield, n = years to maturity)India Context
T-Bills are India's most common zero coupon instruments. RBI has introduced STRIPS for G-Secs. Defined under Section 2(48) of the Income Tax Act. Duration risk is highest among bonds.