A zero coupon bond is a bond that doesn’t pay interest. Instead, it is issued at a discount and increases in face value over time.
The regular interest payments from a normal bond are known as the “coupon,” harking back to a time when bonds came with clippable coupons. The bond holder had to cut them out and physically request payment from the issuer as they came due.
Coupons no longer exist and the vast majority of bonds are held electronically, yet the annualized dollar amount of income they offer is still referred to as “the coupon.” The percentage yield a bond pays is known as the coupon rate.
The zero coupon bond simplified matters by eliminating the need to clip coupons. In modern terms, however, this means that the bond doesn’t pay periodic interest.
Instead, the bond is purchased at a steep discount. For instance, a five-year bond with a face value of $100 might be purchased for the discounted price of $78.35.
Over those five years you earn nothing; there is no income. However, at the end of five years the investor gets $100 from the issuer. This implies an interest rate of 5% per year, paid entirely at maturity.
During those five years the price of the bond can fluctuate on the secondary market. If held to maturity, however, it should pay the full face value.
While no income is earned, the investor can be liable for “phantom” taxes on the implied interest. Because of the tax implications, investors often choose tax-free municipal zero coupon bonds.
The reasons an investor might prefer a zero coupon bond are varied. It might be that income is not an immediate priority, and the eventual payout could be more attractive than that of a normal, interest-paying bond.
Many investors use zero coupon bonds to save for a long-term goal, such as financing retirement or a child’s education. Since the terms of zero coupon bonds are typically a decade or longer, the predictability of the return can be a reassuring way to invest.
That’s not to say zero coupon bonds are less risky than other bonds or that they are risk-free. Nevertheless, the issuers of such bonds include the federal government, state and local governments and large, blue-chip corporations, generally speaking lower-risk propositions.
Moreover, the interest rate implied by the bond can be an indication of the risk one assumes. A higher interest rate might be attractive, but that higher rate could be the result of the market pricing in a comparatively higher risk of default.
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