Zero Coupon Bonds

A zero coupon bond is issued at a steep discount to its face value. No interest is paid until the bond matures at which time the bond holder receives the full face value of the bond. For example you would pay $4,529 for a $10,000 face value zero coupon bond that matures in 20 years with a coupon of 4 percent. You would receive $10,000 of the maturity date, which includes $5,471 of accumulated interest.

Like any marketable security you can hold a zero coupon bond until maturity or you can buy and sell zero coupon bonds in the bond market. Zero coupon bonds are very sensitive to changes in interest rates so bond traders can make quick profits in a changing interest rate environment.

Zero coupons bonds are popular with conservative long-term investors who want to know that a specified amount of money will be available at a future date. With a zero coupon bond you can purchase a bond with a large face value with a relative small amount of money because you buy the bond at a steep discount. For example, parents can buy zero coupon bonds for their children's college education. Or a middle-aged person can buy zeros for his or her retirement.

The types of zero coupon bonds are zero coupon Treasury bonds, zero coupon corporate bonds and zero coupon municipal bonds. Zero coupon Treasury bonds are called STRIPS (Separate Trading of Registered Interest and Principal of Securities). You can buy STRIPS through a broker but not directly from the U.S. Treasury. Each year you must pay federal tax on the computed interest even though you do not receive it until the bond matures. So STRIPS are appropriate for a tax-sheltered retirement account. For more information about STRIPS see Treasury STRIPS.

Before you buy a corporate or municipal zero coupon bond, check its credit risk, call provisions and liquidity.

For more information about zero coupon bonds see What are Zero Coupon Bonds? at The Bond Market Association.

Updated August 20, 2007.