- A zero-coupon bond doesn't pay periodic interest, but instead sells at a deep discount, paying its full face value at maturity.
- Zeros-coupon
bonds are ideal for long-term, targeted financial needs at a foreseeable time. - Though their yields are higher, "zeros" are more volatile than traditional bonds, and they incur taxes each year.
The big appeal of bonds, for many investors, is the interest income they provide. So the idea of buying a bond that doesn't pay any interest may seem, well, paradoxical. Yet a healthy market does exist for such an instrument: the zero-coupon bond, colloquially known as "zeros."
Savvy investors often look to zero-coupon bonds because they can be bought at a deep discount to their face value — that is, the nominal amount they're worth. But when they mature, you receive their full face value. So that's how you profit: the difference between that initial discounted price, and what you collect when the bond comes due.
The biggest draw of zero-coupon bonds is their reliability. If you keep the bond to maturity, you will essentially be guaranteed a sizable return on your investment. That makes them useful for targeted financial needs, like college tuition or down payment on a home.
What is a zero-coupon bond?
Typically, bondholders make a profit on their investment through regular interest payments, made annually or semi-annually, known as "coupon payments." However, as the name suggests, zero-coupon bonds work differently. They have no coupons, and they don't pay interest at a periodic, fixed rate.
That's not to say interest isn't calculated, though. Rather, the bond's interest is totaled up in advance and knocked off the bond's purchase price. Essentially, when you buy a zero, you're getting the sum total of all the interest payments upfront, rolled into that initial discounted price.
For example, a zero-coupon bond with a face value of $20,000 that matures in 20 years with an interest rate of 5.5% might sell for around $7,000. At maturity, two decades later, the investor will receive a lump-sum payment of $20,000 — a $13,000 return on investment. Here, the profit comes from interest that compounds automatically until the bond matures.
The discount can be figured roughly by dividing the bond's face value by its yield and the time remaining until maturity. The math can get a bit complicated, but a zero bond calculator can help you suss it out.
Generally, the more time before the bond matures, the greater the discount.
The US federal government, various municipalities, corporations, and financial institutions all issue zero-coupon bonds. The majority — what most people refer to as zeros — are US Treasury issues.
It is also possible to create a zero-coupon bond from a regular bond by stripping it of its coupons and repackaging it. Often, these repackaged zero-coupon bonds are called STRIPS (Separate Trading of Registered Interest and Principal Securities).
After they're issued, zero-coupon bonds trade on the secondary market like other debt securities.
Advantages of zero-coupon bonds
They often have higher interest rates than other bonds
Since zero-coupon bonds do not provide regular interest payments, their issuers must find a way to make them more attractive to investors. As a result, these bonds often come with higher yields than traditional bonds.
The amount varies, but a US Treasury zero often yields at least one percentage point more than its traditional Treasury counterpart, and sometimes a lot more. In 2018, for example, a 10-year Treasury zero was yielding as much as an annualized 3.1%, while 10-year T-notes were at .2%.
As of November 2020, the current yield-to-maturity rate on the PIMCO 25+ year zero-coupon bond ETF, a managed fund consisting of a variety of long-term zeros, is 1.54%. The current yield on a 20-year Treasury bond is 1.41%.
It may sound small, but thanks to the miracle of compounding, it adds up — especially over time.
They offer a predictable payout
The other big advantage of zero-coupon bonds is their predictability. If these bonds are held to maturity, you're guaranteed a return of the full face value. Plus, you'll have gotten a deal: paying less now for more later.
For this reason, these bonds are a good fit for investors who have a specific financial goal in mind, and a long-term but specific time-frame.
Drawbacks of zero-coupon bonds
They're very sensitive to interest rates
Some bondholders don't want to wait until maturity to get their payout. But if you want to sell your zero early, know that its price is very subject to interest rate fluctuations.
Bond prices have an inverse relationship to interest rates, which means that their market value — their price — falls as interest rates rise. That's true of bonds in general, but zeros are especially sensitive: Since they do not make interest payments, the size of the payoff that you get from the bond depends entirely on its present value at the time that it is sold.
As a result, zero-coupon bond prices are more volatile — subject to greater swings when interest rates change.
You have to pay taxes on income you don't get
Even though you're not actually getting any interest payments, and won't realize the profit on your zero until the bond pays out at maturity, the IRS acts as if you are. It calls this "phantom income" and it wants a piece. So, you likely have to pay taxes on the interest that "accrues" on the bond each year — not just federal, but state and local too.
However, there are ways to avoid this. For instance, you could buy zero-coupon municipal bonds. These aren't subject to federal income taxes, nor to state, if you live in the locality where they're issued.
And Treasury zeros are not taxable on a state or local level, like all Treasury bonds.
There is a default risk
Finally, there is an inherent risk that the issuer of your bond could default, which would render your investment unclaimable. It's not so much a problem with Treasury zeros, which — like most US government issues — are pretty low-risk, but it could be a factor with corporate bond zeros or certain municipal zeros.
If you decide to go this route, you're going to want to choose a company with a strong credit rating.
The financial takeaway
In short, the thing that separates zero-coupon bonds from all other bonds is that you will not receive periodic interest payments from your investment. Instead, you get one lump-sum payment when the bond matures.
As a result, zeros are typically the best fit for buy-and-hold investors who have a particular financial goal in mind, and a particular future time. For example, if you want to finance your child's college education, or have cash ready when you retire, zero-coupon bonds may be a smart move.
You know when you will receive your return on investment and exactly how much the return will be. And you'll have locked it all in at a discount.