What Are Zero Coupon Bonds?

Investing is income-centric. Most of what people call fixed-income bonds offer some form of regular dividends, usually monthly interest installments. But would you be interested in a financial instrument that regularly pays out nothing at all?

They’re called zero coupon bonds. You invest in them, wait until they reach maturity, then get repaid in one lump sum. What are they, and why do some investors like them so much?

How Do Zero Coupon Bonds Work?

The process of buying zero coupon bonds is actually pretty straightforward. Typically, the bonds are offered by big entities like corporations, governments, municipalities, insurers, the Treasury Department and others.

When these bonds are first issued, they carry a certain face value, also called the par value. But they’re sold to investors for anywhere from 20-60% less than the face value. 

After an investor buys the bond, they wait for it to reach maturity, at which point they receive payments for its full face value. They get their original premium back in addition to the difference between it and the face value.

Unlike other fixed-income bonds, zero coupon bonds do not issue regular payments from the interest rate. The only interest the investor receives is the profit they make when the bond matures. 

Pricing of a Zero Coupon Bond

Suppose that a corporation needs to raise some quick capital. Management decides to release bonds with five-year maturity terms at a par value of $1,500. However, the corporation sells the bonds to investors for $1,000, a 33% discount.

After investors snap these bonds up, they wait five years for them to mature. They do not collect interest dividends during those five years. This is why they’re called zero coupon bonds.

When the five years pass, and the bond finally matures, investors receive payments for the full face value of the bond. That’s $1,500 received for a bond they paid only $1,000 for, which means they’ve made $500 in profit.

Entities that issue zero coupon bonds take several price factors under consideration. Market interest rates, demand, yield and competitor pricing all come into play. The issuer’s credit risk also plays a part. Companies with low credit risk can offer more expensive bonds with low yields. Those with high credit risk must price their bonds lower but with much greater yields.

Advantages of Zero Coupon Bonds

Some of the potential benefits of investing in zero coupon bonds include the following:

• Dependable return when the bond matures
• Higher returns for bonds sold at big discounts
• Possibility of deferring taxes until the bond matures
• Easier to use for long-term savings goals and future expenses
• Limited exposure to interest rate fluctuations

Disadvantages of Zero Coupon Bonds

As with any investment strategy, there can be a few pitfalls to zero coupon bonds, such as:

• No regular interest payments during the bond term
• Possible interest rate exposure and capital loss if the bond is sold before maturity
• Very limited liquidity or cash conversion ability
• Must report the annual imputed interest on taxes
• Credit risk on certain bond issuers — if they default, investors could lose capital

Investment Strategies and Considerations

Many of the strategies for zero coupon bonds are similar to those of general bonds and debt instruments. Below are some of the most well-known strategies, as well as other aspects to think about. 

Buy and Hold

Zero coupon bonds align well with the buy-and-hold concept of investing. They have a guaranteed date of maturity, with their low liquidity making it easier to hang on to the bonds until that time. Zero coupon bonds with longer terms hold the potential for deeper discounts and higher returns. 

Ladder Strategy

Another popular strategy is building a ladder of bond holdings with staggered dates of maturity. For example, you might stack three zero-coupon bonds of three-, five- and seven-year terms. When a bond with a three-year maturity term expires, you might consider reinvesting the returns in seven-year bonds. This generates a rotating schedule of guaranteed returns.

Compare Your Choices

With so many zero coupon bonds to choose from, it’s essential to research your available choices. When looking into zero coupon bonds, make sure you consider these factors:

• Market prices
• Maturity date
• Yield to maturity (the total return you’ll get if you hold on the bonds)
• Liquidity
• Exposure to inflation
• Costs and fees

Feel free to research other factors you deem important as well. 

Taxes

Although zero coupon bonds do not pay regular interest revenue, they can still be subject to tax. The difference between the full par value and the discounted purchase price is called imputed interest.

This means that, even though annual regular interest payments are not paid to zero coupon investors, tax authorities can treat them as having been paid. That just means they’re taxable.

Tax laws vary by state and country. Find out what local, state or federal tax regulations zero coupon bonds are subject to before you invest. You should also consider whether tax deferral is possible because it may be, especially if it’s held in a 401(k) plan. 

Risk Assessment

Zero coupon bonds are no riskier than traditional bonds. But investors may encounter certain risks.

For instance, interest rate fluctuations can affect a bond’s value over time; it’s lower when rates are raised and higher when they’re reduced. All bond issuers should also be evaluated for their credit risk. If the issuer defaults on their repayment, you may lose some of your investment.

Call risk is another factor to consider. There might be cases in which the bond issuer decides to cash in or call the bond before it hits maturity. This can send bondholders scrambling to reinvest to make up the difference. Also, make sure to account for risks of exposure to inflation and market movements. 

Zero Coupon Bonds vs. Other Types of Bonds

The primary difference between zero coupon bonds and traditional bonds is the absence of interest revenue payouts. Most traditional bond issuers make regular payments on interest to investors during the bond term. A zero coupon bond issuer does not pay out profit until the bond matures.

Both kinds of bonds are influenced by interest rate changes, though zero coupon bonds may be slightly more susceptible. Since traditional bonds issue coupons regularly, the interest rate impact on them is more diffuse.

Most investors see bonds as relatively low-risk long-term instruments. Zero coupon bonds are slightly more suited to long-term investors who want an expected return upon maturity. Other traditional bonds have a wider range of outcomes regarding risk, maturity and payout. 

Where to Buy Zero Coupon Bonds

This table shows some of the outlets you can use to invest in zero coupon bonds. 

Is It Zero Hour for Your Portfolio?

Zero coupon bonds have been around since 1960 when the U.S. Treasury first issued bonds known today as STRIPS. Getting no recurring interest payments may seem counterproductive to investment theory. But for those who want a near-guaranteed payout after years of passive capital appreciation, a zero coupon bond may be just the ticket. 

Frequently Asked Questions