Zero Coupon Bonds

What is a zero coupon bond?

The term "zero coupon" refers to a debt instrument that does not make coupon payments, but, rather, is issued at a discount to par and redeemed at par at maturity. (Source: CFTC)

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus interest that has accrued.

The maturity dates on zero coupon bonds are usually long-term—many don’t mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the deep discount, an investor can put up a small amount of money that can grow over many years.

Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities.

Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. In addition, although zero coupon bonds do not pay any interest until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying the imputed tax by buying municipal zero coupon bonds (if they live in the state where the bond was issued) or purchasing the few corporate zero coupon bonds that have tax-exempt status. (Source: SEC)

Zero coupon bonds are bonds which do not pay periodic interest payments, or so-called "coupons". Zero coupon bonds are purchased at a discount from their value at maturity. The holder of a zero coupon bond is entitled to receive a single payment, usually of a specified sum of money at a specified time in the future. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond.

In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.

Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets.

Short term zero coupon bond generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world. (Source: Wikipedia)