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.

Why Should You Invest in Zero Coupon Bonds?

Investing in financial instruments requires careful consideration of various options. Each option has its own characteristics and benefits. Zero coupon bonds are notable for their unique structure and advantages. These bonds are issued at a discount to their face value. They do not pay periodic interest. Instead, they yield a return only at maturity when the bondholder receives the full face value. This feature makes zero coupon bonds attractive for low-risk investors seeking predictable returns. They also offer tax benefits and the potential for significant capital appreciation. This makes them suitable for long-term savings and wealth accumulation. In the following sections, we will explore the key reasons why investing in zero coupon bonds can be a strategic move for your financial portfolio.

Predictable Returns

One of the most compelling features of zero-coupon bonds is their predictability. These bonds are issued at a discount to their face value and do not pay periodic interest. Instead, they accumulate interest over time and mature at their full face value. This structure allows investors to know exactly how much they will receive at maturity, making zero-coupon bonds a reliable choice for those with specific financial goals. For example, if you plan to fund a child's education or save for retirement, you can purchase a zero-coupon bond that matures when you need the funds. This predictability can help you plan your finances more effectively, knowing exactly when and how much you will receive.

Tax Advantages

Zero-coupon bonds also offer significant tax advantages that can enhance their appeal. In many jurisdictions, the imputed interest on these bonds is not taxed until the bond matures or is sold, allowing for tax-deferred growth. This means that you can reinvest your earnings without facing immediate tax implications, maximizing your investment potential over time. Additionally, because they do not pay regular interest, zero-coupon bonds can be a strategic choice for investors in higher tax brackets. By deferring taxes, investors can enjoy the benefits of compounding returns, ultimately leading to greater wealth accumulation.

Interest Rate Protection and Capital Gains Potential

Zero-coupon bonds tend to be more sensitive to interest rate fluctuations than traditional coupon bonds. This heightened sensitivity can lead to significant price appreciation in a declining interest rate environment. When interest rates fall, the prices of zero-coupon bonds can rise substantially, providing investors with the opportunity for capital gains. This can be particularly beneficial during periods of economic uncertainty or when interest rates are expected to decline. While the potential for volatility exists, this characteristic can make zero-coupon bonds a valuable addition to a diversified portfolio, offering both stability and the chance for higher returns.

Risks Associated with Investing in Zero Coupon Bonds

Investing in zero coupon bonds can offer unique opportunities for long-term savings or capital appreciation. However, it also carries distinct risks. Unlike traditional bonds, zero coupon bonds are sold at a discount. They do not pay periodic interest. Their value depends solely on interest rate changes and the issuer's creditworthiness. This means that investors face potential risks such as interest rate risk, reinvestment risk, and credit risk. It is essential to understand these risks to manage a successful investment strategy. Keeping one's financial goals aligned with their risk tolerance is important. Let’s explore the specific risks associated with investingin zero coupon bonds.

Interest Rate Risk

Zero-coupon bonds are very sensitive to changes in interest rates. When interest rates rise, the market value of existing zero-coupon bonds usually drops more than that of traditional coupon bonds. This is because zero-coupon bonds do not provide periodic interest payments. Their value relies solely on the difference between the purchase price and the face value at maturity. As rates go up, new bonds are issued with higher yields. This makes older zero-coupon bonds less attractive. Selling them before maturity can lead to significant capital losses.

Lack of Income During Holding Period

Zero-coupon bonds do not offer periodic interest payments, unlike coupon bonds. This can be a disadvantage for certain investors. Those who rely on regular income, like retirees, may find this challenging. The lack of income means investors must wait until maturity to see any return. This situation can limit liquidity and flexibility. If an investor needs to sell their bond before maturity, they might face unfavorable market conditions. This could lead to potential losses.

Credit Risk

Zero-coupon bonds, like all bonds, carry credit risk. This is the risk that the issuer may default on their obligations. If the issuer fails to meet their debt obligations, investors could lose some or all of their investment. This risk is especially significant for zero-coupon bonds issued by corporations or municipalities. These issuers may have different credit ratings. Investors should carefully evaluate the creditworthiness of the issuer before investing. Government-issued zero-coupon bonds, such as U.S. Treasury bonds, are generally considered low-risk. However, other issuers may present a higher risk of default.

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