- A zero-coupon bond doesn’t pay periodic interest, but instead sells at a deep discount, paying its full face value at maturity.
- Zeros-coupon bonds are ideal for long-term, targeted financial needs at a foreseeable time.
- Though their yields are higher, “zeros” are more volatile than traditional bonds, and they incur taxes each year.
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The big appeal of bonds, for many investors, is the interest income they provide. So the idea of buying a bond that doesn’t pay any interest may seem, well, paradoxical. Yet a healthy market does exist for such an instrument: the zero-coupon bond, colloquially known as “zeros.”
Savvy investors often look to zero-coupon bonds because they can be bought at a deep discount to their face value — that is, the nominal amount they’re worth. But when they mature, you receive their full face value. So that’s how you profit: the difference between that initial discounted price, and what you collect when the bond comes due.
The biggest draw of zero-coupon bonds is their reliability. If you keep the bond to maturity, you will essentially be guaranteed a sizable return on your investment. That makes them useful for targeted financial needs, like college tuition or down payment on a home.
What is a zero-coupon bond?
Typically, bondholders make a profit on their investment through regular interest payments, made annually or semi-annually, known as “coupon payments.” However, as the name suggests, zero-coupon bonds work differently. They have no coupons, and they don’t pay interest at a periodic, fixed rate.
That’s not to say interest isn’t calculated, though. Rather, the bond’s interest is totaled up in advance and knocked off the bond’s purchase price. Essentially, when you buy a zero, you’re getting the sum total of all the interest payments upfront, rolled into that initial discounted price.
For example, a zero-coupon bond with a face value of $20,000 that matures in 20 years with an interest rate of 5.5% might sell for around $7,000. At maturity, two decades later, the investor will receive a lump-sum payment of $20,000 — a $13,000 return on investment. Here, the profit comes from interest that compounds automatically until the bond matures.
The discount can be figured roughly by dividing the bond’s face value by its yield and the time remaining until maturity. The math can get a bit complicated, but a zero bond calculator can help you suss it out.
Generally, the more time before the bond matures, the greater the discount.
The US federal government, various municipalities, corporations, and financial institutions all issue zero-coupon bonds. The majority — what most people refer to as zeros — are US Treasury issues.
It is also possible to create a zero-coupon bond from a regular bond