What Is a Zero-Coupon Bond?
Let me explain to you what a zero-coupon bond is—it's a type of debt investment that doesn't pay any interest during its life. Instead, you buy it at a deep discount, and you get your profit when it matures and you redeem it for its full face value.
You might also hear it called an accrual bond.
Key Takeaways
- A zero-coupon bond doesn't pay interest to the holder.
- Zero-coupon bonds are purchased at a deep discount to face value but they're repaid at full face value or par at maturity.
- The difference between the purchase price of a zero-coupon bond and its par value is the investor's return.
- They can be subject to interest rate risk if investors sell them before maturity.
The Basics of Zero-Coupon Bonds
Some bonds start out as zero-coupon instruments right from issuance, while others get turned into them when a financial institution strips off the coupons and repackages them as zero-coupon bonds.
Since they pay out the face value at maturity, zero-coupon bonds tend to swing in price a lot more on the secondary market than regular coupon bonds.
What Is a Bond?
A bond is essentially a way for a company or government to borrow money from you, the investor— you're lending them cash, and in return, you get coupon payments, usually semiannually or annually, throughout the bond's life.
When the bond matures, you get back the face value, which for corporate bonds is typically $1,000.
If a bond is issued at a discount, you can buy it below par—say, for $920—and at maturity, you receive $1,000, so your return is that $80 plus any coupons.
But not all bonds come with those coupon payments; the ones without are zero-coupon bonds.
How Zero-Coupon Bonds Work
Zero-coupon bonds are issued at a deep discount, and they repay the par value at maturity—the difference between what you pay and what you get back is your return. That payment includes your principal plus the interest that's compounded semiannually at the stated yield.
The interest here is imputed—it's an estimate, not a fixed rate. For example, a bond with a $20,000 face value maturing in 20 years at 5.5% yield might cost you about $6,855 now, and you'd get $20,000 later.
The $13,145 difference is the interest compounding until maturity, often called phantom interest.
You have to pay federal income tax on this imputed interest each year, even though you don't get any cash until maturity. State and local taxes might apply too.
To avoid those taxes, you could buy municipal zero-coupon bonds, hold them in a tax-exempt account, or choose corporate ones with tax-exempt status.
Pricing a Zero-Coupon Bond
You can calculate the price of a zero-coupon bond with this formula: Price = M ÷ (1 + r)^n, where M is the maturity value, r is the required interest rate, and n is the years until maturity.
For instance, if you want a 6% return on a $25,000 par bond maturing in three years, you'd pay $25,000 / (1 + 0.06)^3 = $20,991.
That means the bond sells at 84% of face value, and at maturity, you gain $4,009, which works out to 6% per year.
Remember, the longer until maturity, the cheaper the bond is now, and shorter terms mean you pay more upfront.
These bonds usually have long maturities, at least 10 years, which helps with planning big goals like saving for your child's college—you invest a small amount that grows over time thanks to the discount.
You can get zero-coupon bonds from the U.S. Treasury, state or local governments, or corporations, and most trade on major exchanges.
How Does a Zero-Coupon Bond Differ From a Regular Bond?
The main difference is the interest payments—regular bonds, or coupon bonds, pay interest throughout their life and return principal at maturity.
Zero-coupon bonds skip the interest payments and trade at a deep discount, so you profit when you redeem them at full face value.
How Does an Investor Price a Zero-Coupon Bond?
Focus on the imputed interest rate you'll earn at maturity. Use this equation: Zero-coupon bond price = Maturity value ÷ (1 + required interest rate)^number years to maturity.
How Does the IRS Tax Zero-Coupon Bonds?
Imputed interest, or phantom interest, is the estimated rate, and it's taxable. The IRS uses an accretive method for Treasury bonds, setting a minimum rate based on the imputed interest and the original discount.
The Bottom Line
Zero-coupon bonds offer an alternative to regular coupon bonds that pay ongoing interest—you buy them at a deep discount and get repaid at full price.
They're typically long-term, often 10 years or more, ideal for goals like funding education.
One key point for you to consider: you pay taxes on the phantom interest each year you hold them.
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