What is a Zero Coupon Bond?
A zero coupon bond is a bond that makes no periodic interest payments and is sold at a deep discount from 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.
How Does a Zero Coupon Bond Work?
The price of a zero-coupon bond can be calculated by using the following formula:
P = M / (1+r)n
P = price
M = maturity value
r = investor's required annual yield / 2
n = number of years until maturity x 2
For example, if you want to purchase a Company XYZ zero-coupon bond that has a $1,000 face value and matures in three years, and you would like to earn 10% per year on the investment, using the formula above you might be willing to pay:
$1,000 / (1+.05)6 = $746.22
When the bond matures, you would get $1,000. You would receive "interest" via the gradual appreciation of the security.
The greater the length until a zero coupon bond's maturity, the less the investor generally pays for it. So if the $1,000 Company XYZ bond matured in 20 years instead of 3, you might only pay:
$1,000 / (1+.05)40 = $142.05
Zero-coupon bonds are very common, and most trade on the major exchanges. Corporations, state and local governments, and even the U.S. Treasury issue zero-coupon bonds. Corporate zero-coupon bonds tend to be riskier than similar coupon-paying bonds because if the issuer defaults on a zero-coupon bond, the investor has not even received coupon payments -- there is more to lose.
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. The IRS calls this "imputed interest." It's also commonly referred to as "phantom income" or "phantom interest."
Why Does a Zero Coupon Bond Matter?
Zero-coupon bonds are usually long-term investments; they often mature in ten or more years. Although the lack of current income provided by zero-coupon bonds discourages some investors, others find the securities ideal for meeting long-range financial goals like college tuition. The deep discount helps the investor grow a small amount of money into a sizeable sum over several years.
Because zero-coupon bonds essentially lock the investor into a guaranteed reinvestment rate, purchasing zero-coupon bonds can be most advantageous when interest rates are high. They are also more advantageous when placed in retirement accounts where they remain tax-sheltered. Some investors also avoid paying taxes on imputed interest by buying municipal zero-coupon bonds, which are usually tax-exempt if the investor lives in the state where the bond was issued.
The lack of coupon payments on zero-coupon bonds means their worth is based solely on their current price compared to their face value. Thus, prices tend to rise faster than the prices of traditional bonds when interest rates are falling, and vice versa. The locked-in reinvestment rate also makes them more attractive when interest rates fall.