Q: The largest component of returns for a 7 year zero coupon bond yielding 8% and held to maturity is:
A. Capital Gains
B. Interest Income
C. Reinvestment Income
I said A, as ZCBs are generally purchased at deep discount to par value. However the answer was B. I know that C is incorrect.
The answer was B. Can anyone explain why?
Note that for tax purposes in certain jurisdictions (not sure about AUS) a fictitious interest income is assumed for income tax purposes in order not to defer the whole taxable capital gain to the future. That means that the annual increase in value of a zero coupon over the lifetime aproaching par would be accounted as interest income.
As this bond is held till maturity , capital gain is zero because the price lies on bond price trajectory.
The return is only in the form of interest (which is taxable ) , so largest component of return is interest .