What are Zero Coupon Bonds?
A zero coupon bond is a bond that makes no periodic interest payments and therefore is sold at a deep discount from its face value. The buyer of the bond receives a return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date.
Investors can purchase zero coupon bonds from places such as the major exchanges, government entities (such as the U.S. Treasury), and private corporations. The return is based on the difference between the value and purchase price of the bond. Payment is typically made semiannually, which includes both the principal and 'implied interest' earned.
Calculating the Price of a Zero Coupon Bond
The price of a zero-coupon bond can be calculated by using the following formula:
M = maturity (or face) value
r = investor's required annual yield / 2
n = number of years until maturity x 2
P = Price
The idea behind calculating the price of a zero coupon bond is so that you can determine the price you want to pay for the investment, based on the returns you want to earn.
Example of a Zero Coupon Bond
Using the formula above you might be willing to pay:
$1,000 / (1+0.025)^6 = $862.30
If this bond matured in 20 years instead of 3, the price you pay will differ:
$1,000 / (1+0.025)^40 = $372.43
In other words, all else equal, the greater the length until a zero coupon bond's maturity or the greater the rate of return, the less the investor will pay.
How Interest Rate Fluctuations Affect the Price of Zero Coupon Bonds
Zero coupon bonds are sensitive to interest rate fluctuations. The price you can get on the open market will be determined by current interest rates. If you purchased a zero coupon bond at 5% and interest rates rose and offered a 10% yield, your zero coupon bond won't look as attractive because of the lower return.
In order for yours to remain attractive to investors, the price will need to drop until the bond yields a 10% return.
How are Zero Coupon Bonds Taxed?
The IRS refers to earnings from a zero coupon bond as 'imputed interest,' (also commonly known as 'phantom interest' or 'implied interest') which is the difference between the bond's face value and the amount you'll receive.
For tax purposes, the IRS maintains that the holder of a zero-coupon bond owes income tax on the interest that has accrued each year, even though the bondholder does not actually receive the cash until maturity.
So for our first example above, if you purchased a bond for $862.30 which will return $1,000 after 3 years you effectively earn $45.90 per year. (137.70 total earnings/ 3 years)
You would pay income taxes on the $45.90 each year.
Advantages of Zero Coupon Bonds
Zero coupon bonds tend to offer higher interest rates, providing better earnings for investors compared to traditional bonds. Plus, they're predictable -- investors are essentially guaranteed a payout if held until maturity.
Disadvantages of Zero Coupon Bonds
A main drawback is that zero coupon bonds are at the mercy of interest rate fluctuations, especially when investors sell before maturity. Since this type of security doesn't make interest payments, the payout will depend on its present value when an investor sells the bond.
As with all investments, there is risk, even with these types of bonds. The bond issuer could go into default, though ones issued by the government are fairly risk-free. Let's not forget that even if you're not receiving interest payments, the IRS will still require you to pay taxes as though you have.
How to Buy Zero Coupon Bonds
Investors can purchase zero coupon bonds through a registered investment advisor (RIA), full-service broker dealer, or a self-managed brokerage account. There are plenty of options such as mutual funds or ETFs focused on corporate, municipal, and some government bonds.
For instance, you can purchase the Vanguard Extended Duration Trs ETF through Vanguard (an online brokerage) -- the process to buy and sell is similar to how you would purchase individual stocks.
Investors can also go through the TreasuryDirect website for U.S. Treasury bonds.