Zero-coupon bonds are a distinctive type of debt security that offers a unique investment opportunity. Unlike traditional bonds that pay periodic interest payments, zero-coupon bonds do not make any interest payments throughout their term. Instead, they are purchased at a significant discount to their face value and mature at par, providing investors with a return on their investment.
How zero-coupon bonds work
Imagine buying a discounted gift card for a future purchase. You pay less upfront, but you’ll receive the full value when you redeem it. A zero-coupon bond works similarly.
When you purchase a zero-coupon bond, you’re essentially lending money to the issuer, such as a government or a corporation. Instead of receiving periodic interest payments (like coupons), you buy the bond at a significant discount to its face value.
The difference between the purchase price and the face value represents the interest you’ll earn on the bond. This interest, known as “imputed interest,” accrues over time. It’s like earning interest on a savings account, but you don’t receive the interest payments until the bond matures.
Suppose you buy a $1,000 zero-coupon bond with a 10-year maturity for $614. The $386 difference is the imputed interest you’ll earn over the 10 years. A portion of this interest is added to the bond’s value each year, even though you don’t receive any physical payment. At the end of the 10 years, you’ll receive the full $1,000 face value.
Key features of zero-coupon bonds
Zero-coupon bonds offer a unique investment opportunity with several key features that set them apart from traditional bonds:
- No interest payments: Zero-coupon bonds don’t pay periodic interest.
- Deep discount purchase: You buy the bond at a significant discount to its face value.
- Maturity date: The bond matures at its face value.
- Imputed interest: The difference between the purchase price and the face value is taxable income, even though you don’t receive it until maturity.
Advantages of zero-coupon bonds
Zero-coupon bonds offer several advantages that can make them an attractive investment option for certain investors:
- Long-term investment: Zero-coupon bonds are ideal for long-term investment goals, such as retirement savings or a child’s education.
- Potential for high returns: If you hold the bond to maturity, you’ll receive the full face value, which can lead to significant returns, especially over longer time horizons.
- Tax efficiency: In some cases, you may be able to defer taxes on the accrued interest until the bond matures.
Disadvantages of zero-coupon bonds
While zero-coupon bonds offer several advantages, they also come with certain drawbacks:
- Interest rate risk: If interest rates rise after you purchase the bond, its value may decrease.
- Lack of liquidity: Zero-coupon bonds can be less liquid than other bonds, making it difficult to sell them before maturity.
- Tax implications: The imputed interest on zero-coupon bonds is subject to income tax each year, even though you don’t receive any cash payments.
Example: Zero-Coupon Treasury STRIPS
Zero-coupon bonds can take many forms, including Treasury STRIPS. STRIPS, or Separate Trading of Registered Interest and Principal Securities, are created by separating a Treasury security’s interest and principal payments into individual zero-coupon securities. Investors can purchase individual interest or principal payments, providing maturity and risk profile flexibility.
For example, a 10-year Treasury note can be stripped into 20 individual zero-coupon securities: 19 interest payments and one principal payment. These securities can be traded separately, offering investors a range of maturity options and potential returns.
STRIPS offer several advantages, including:
- Tax efficiency: The interest earned on STRIPS is generally subject to federal income tax but exempt from state and local taxes.
- Predictable returns: Since STRIPS are zero-coupon securities, their future value is known at the time of purchase, providing investors with a predictable return.
- Liquidity: STRIPS are actively traded on the secondary market, making them a relatively liquid investment.
However, it’s important to note that STRIPS are subject to interest rate risk. If interest rates rise after purchasing a STRIP, the value of the bond may decline. Additionally, STRIPS can be more complex than traditional bonds, so it’s advisable to consult with a financial advisor before investing in bonds.
