The ABCs of Zero Coupon Bonds
At first blush, the idea of a bond that doesn’t pay interest seems oxymoronic. After all, isn’t a bond a debt instrument that pays periodic interest and repays the principal at maturity?1
Zero coupon bonds are indeed debt instruments, but are issued at a discount to their face value, make no interest payments, and pay its face value at time of maturity.
How Does it Work?
Let’s say, a hypothetical zero coupon bond is issued today at a discount price of $743 with a face value of $1,000, payable in 15 years. If you buy this bond, hold it for the entire term and receive the face-value payment, the difference of $257 represents the interest you earned. In this hypothetical example, the bond’s interest rate would amount to approximately 2 percent.
Zero coupon bonds are predominantly issued by the federal government, and typically, they are issued with maturities of 10 to 15 years.
Zero coupon bonds are traded on recognized financial markets and exchanges, which may offer investors liquidity in the event they choose not to hold them to maturity.
One of the biggest risks of zero coupon bonds is their sensitivity to swings in interest rates. In a rising interest rate environment, their value is likely to fall more than other bonds.
Zero coupon bonds are subject to an unusual taxation in which the receipt of interest is imputed each year, requiring holders to pay income taxes on what is called “phantom income.”
For individuals, zero coupon bonds may serve several investment purposes. Zeros may be bought to fund specific future financial obligations, e.g., college savings. By placing them in a U.S. Treasury zero, a parent can be assured that the funds are expected to be fully intact to meet this liability.2
As with any investment, a zero coupon bond’s appropriateness hinges on your individual needs and circumstances. Understanding some of the basic concepts may help you better assess whether they might have a place in your portfolio.
1. The market value of a bond will fluctuate with changes in interest rates. As rates rise, the value of existing bonds typically falls. If an investor sells a bond before maturity, it may be worth more or less than the initial purchase price. By holding a bond to maturity an investor will receive the interest payments due plus your original principal, barring default by the issuer. Investments seeking to achieve higher yields also involve a higher degree of risk.
2. U.S. Treasury zero coupon bonds are guaranteed by the federal government as to the payment of principal and interest. However, if you sell a Treasury zero coupon bond prior to maturity, it could be worth more or less than the original price paid.