Zero-coupon bonds, sometimes known as zeros, are issued at a deep discount to par value and pay no interest during their term.
At maturity, the bondholder receives par value, which includes the interest that has accrued since issue. For example, you may purchase a zero-coupon bond with a six-year term for $13,500, and collect $20,000 at maturity.
One advantage of zeros is that you can invest relatively smaller amounts and choose maturity dates to coincide with times you know you'll need the money - for example, when you expect college tuition bills to come due.
One drawback of zeros, however, is that income taxes are due annually on the interest that accrues, even though you don't receive the actual payment until the bond matures.
The exception occurs if you buy tax-exempt municipal zeros, on which no tax is due either during the term or at maturity. Another drawback is that zero coupon bonds are volatile in the secondary market, so if you have to sell before maturity, you might have a loss.
These bonds get their name - zero coupon - from the fact that coupon means interest in bond terminology, and there's no periodic interest.
- Browse Related Terms: Callable bond, Conversion price, Convertible bond, Deep discount bond, Exchange traded notes, Gilt-edged security, Indenture, Noncallable, Original issue discount, Par Value, Prerefunding, Redemption, Sinking fund, Zero-coupon bond, Zero-coupon convertible bond
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