A Zero-Coupon Bond does not make periodic interest payments or “coupons” to the investors. Since the coupon rate of such bonds are ‘zero’ they are called as zero-coupon bond. In case of Zero-Coupon Bonds the issuer sells the bonds at a price less than the face value of the bonds and pays to the bond holders the face value of the bonds when bonds are redeemed on maturity date. Here, in effect, the discount given on the zero coupon bonds represent the ‘interest’ the bonds pays to the investors. In contrast, the issuer of normal bonds makes coupon (interest) payment annually or semi-annually and the bond holders (investor) and bonds can be redeemed at face value on maturity.
Let us take an example that the Government has issued Zero-Coupon bonds of face value Rs.1100 with maturity period of one year and bonds are sold for Rs.1000. In the above case, the government is offering 10% return to the investors.
Calculation: Face Value less bond purchase price= Rs.1100-Rs.1000= Rs.100. Thus, the return on purchase price of Rs.1000 for one year is Rs.100/-. It means 10% return on the investments of above bonds.
Since Zero-coupon bonds are sold at a large discount, they are also known as discount bonds or deep discount bonds. They may be long or short term investments. Short term bonds are for the period less than one year (called as treasury bills) and the long term bonds are usually for the duration of 10 to 15 years. The investors can sell or buy these bonds in secondary market.