Zero Coupon Bonds
Zero coupon bonds are a debt security that does not have periodic interest payments. The bond, issued at a deep discount from par value, compensates for the lack of interest payments. Then they are redeemed at par value at maturity.
Banks or dealers create strip bonds, synthetic zero-coupon bonds. Therefore, separate the principal amount (the corpus) from the interest payments (the coupon payments) and sell the two parts separately to investors. Thus, this creates zero-coupon bonds. The investors then receive a lump sum at the maturity date, equal to the value of corpus or the coupon payments, depending on their contract. The contracts are known as STRIPS (Separate Trading of Registered Interest and Principal of Securities).
According to the IRS, the holder of a zero-coupon bond owes income tax on the bond’s imputed interest. Imputed interest refers to the implied periodic interest payments that the bondholder does not actually receive until maturity. Imputed interest on zero-coupon bonds issued by municipalities is tax exempt.