What is a zero-coupon bond?
A zero-coupon bond is a type of bond that pays zero interest, but that you can buy at a substantial discount to face value, and redeem later for full face value when it matures. Zero-coupon bonds are issued by federal, state, and local governments and private corporations. They have long terms, typically 10 years or more.
Since zero-coupon bonds don’t make interest payments, the return to the bondholder occurs at maturity, when the bondholder receives full value on the bond that they purchased earlier at a discount. The discount depends on prevailing interest rates at the time of purchase, as well as the term and the risk of the bond.
How do zero-coupon bonds work?
With a zero-coupon bond you receive “interest” through the appreciation of the bond and the profit when you redeem it for full face value. If you’re considering the purchase of a zero-coupon bond instead of a regular bond, you can estimate the price you would pay from this formula
Purchase price = Face value / (1 + i) ^ t
where i is the annual interest rate you would like to receive and
t is the term of the bond in years
For example, if you would like to receive 10% per year on a bond that matures in 10 years, the price you might be willing to pay is
$1,000 / (1 + .10)^10 = $385.54
The actual discount also depends on the risk of the bond. Because they have such long terms, the risk of zero-coupons is a large consideration for investors. The risk depends on the financial condition of the organization that issues the bonds. Bonds issued by the U.S. Treasury are considered safest because they are backed by the full faith and credit of the U.S. government. Bonds issued by local governments and private companies are higher risk and come with a potentially higher return.
What are some benefits of zero-coupon bonds?
The lack of regular interest payments turns away some investors from zero-coupon bonds, but others find them useful for long-range goals like retirement savings or college tuition. With a zero-coupon you know what payment you will receive and when you will receive it, so it is useful for making major investments with predictable dates.
Zero-coupons are also useful for passing assets to their heirs. If you pass a zero-coupon to your beneficiary, only the purchase price counts against the gift tax exclusion, but your beneficiary receives a greater amount when the bond matures.
Like all bonds, the market value of zero-coupons fluctuates with interest rates. The value of zero-coupon bonds depends entirely on their market price compared to their face value. Therefore, the price of zero-coupons tends to change more with interest rates than the prices of ordinary bonds.
As a zero-coupon bondholder, you are required to pay income tax on the interest that has accrued each year, even though you don’t receive it until maturity. Only municipal zero-coupon bonds are typically exempt from taxes.