Zero Coupon Bond
A zero coupon bond is a debt instrument that pays no periodic interest; instead it is issued at a deep discount to its face value and redeemed at par at maturity, with the difference representing the investor's return.
Zero coupon bonds (ZCBs) are issued across the sovereign and corporate spectrum in India. The Government of India has issued zero coupon bonds as part of its recapitalisation programme for public sector banks — notably in the 1990s when the government capitalised banks by issuing ZCBs instead of cash, which avoided immediate cash outflow while meeting statutory capital requirements. These instruments were not tradeable in the secondary market and were held to maturity by banks.
In the corporate market, ZCBs are occasionally structured as part of hybrid instruments or within securitisation structures. An issuer benefits because there is no periodic coupon payment obligation — useful for companies in early-stage capital expenditure phases with limited near-term cash flows. The investor accepts reinvestment risk at the time of purchase because the entire return is locked in at the issue yield; there are no intermediate coupons to be reinvested at uncertain future rates.
The pricing formula for a ZCB is straightforward: Price = Face Value ÷ (1 + YTM)^n, where YTM is the yield to maturity and n is years to maturity. As interest rates rise, ZCB prices fall more sharply than coupon-bearing bonds of the same maturity because the duration of a ZCB equals its tenor — the highest possible duration for any bond of that maturity. This makes ZCBs the most interest-rate-sensitive instruments available.
Tax treatment of ZCBs in India can be complex. For listed ZCBs, the discount is treated as a capital gain rather than interest income, and the tax treatment depends on the holding period (short-term or long-term). For unlisted ZCBs, the income may be spread across the holding period as deemed interest under the Income Tax Act, even though no cash is received — creating an accrual tax liability that can be a cash flow management challenge for investors.
ZCBs are conceptually important for bond mathematics: the yield curve is formally constructed from the yields of zero coupon instruments (spot rates), and any coupon-bearing bond can be decomposed into a portfolio of zero coupon cash flows to derive its theoretical fair value.