Bonds are often part of many long-term investors’ portfolios because of their ability to add diversification, potentially minimize risk and bring in income. While there are many different types of bonds, zero-coupon bonds offer unique characteristics compared to other types of fixed income investing.
Here’s what you need to know about zero-coupon bonds.
What is a zero-coupon bond?
A zero-coupon bond is a type of bond that pays no interest and trades at a discounted face value. The investor pays less than the bond’s face value and later receives the full value of the bond at maturity, with the difference comprising the investor’s return.
To put it another way: The investor’s return is the difference between the purchase price and the face value, which essentially acts as the “interest” earned over time. For example, you might pay $5,000 for a zero-coupon bond with a face value of $10,000 and receive the full price, $10,000, upon maturity in 20 or 30 years. Zero-coupon CDs work the same way.
Zero-coupon bonds are issued by federal agencies, governments, corporations and other financial institutions. These bonds largely appeal to investors who want to lock in a set return for a specified period in time, usually for education or retirement purposes, but it varies person-to-person.
Types of zero-coupon bonds
Zero-coupon bonds, or zeros, come in a few varieties, just like standard coupon-paying bonds. Bonds that can be structured as zero-coupon bonds include:
Zero-coupon bonds can even be created from standard bonds. One type of zero-coupon bonds is strip bonds from the U.S. Treasury, or STRIPS (Separate Trading of Registered Interest and Principal of Securities). When a regular Treasury bond is issued, it has both a principal amount (what you receive when the bond matures) and interest payments (coupons). These components may be separated, allowing each payment to be sold as a zero-coupon bond.
What are the pros and cons of zero-coupon bonds?
A bond that doesn’t pay interest might seem a little paradoxical compared to the typical expectation of investing in bonds, but there might be a right time to invest in a zero-coupon bond depending on your financial goals.
Pros
- Guaranteed income: Because a zero-coupon bond is purchased at a discount and matures at a fixed value, investors know exactly how much they’ll be getting when the bond matures. This predictability can make zero-coupon bonds attractive to investors who have planned expenses, like paying for college or retirement.
- Lower initial investment: Zero-coupon bonds are known for being more affordable because they’re purchased at a discounted face value. For example, an investor could purchase a zero-coupon bond with a face value of $1,000 for $600.
- Reduced reinvestment risk: By holding the bond until maturity (often 10 or more years) investors can benefit from the full appreciation of the bond. In other words, the investor gets a preset rate for the life of the bond, which compounds over time as you get closer to the face value and realize that rate.
Cons
- Volatility and interest rate risk: Without regular interest payments to cushion price fluctuations, zero-coupon bonds are more volatile than short-term bonds. In general, the current value of any long-term bond and its distant cash flow fall when interest rates rise. That sensitivity to interest rates is even higher with zero-coupon bonds, where the payout comes at the end of the bond’s life instead of the regular payments offered by short-term bonds.
- Taxes before income: Though zeros don’t pay coupons, investors are still required to pay taxes on the interest earned over time and may pay taxes annually on the phantom interest for decades. This liability can make zero-coupon bonds less tax-efficient for some investors.
- Commitment: Zero-coupon bonds are intended to be a long-term commitment, usually spanning 10 to 30 years. For investors who need access to liquidity before the bond matures, zero-coupon bonds may not be the best option. Zero-coupon bonds can be sold before maturity, though, if there’s sufficient market liquidity. This liquidity can provide potential flexibility despite the long-term timeline for zero-coupon bonds.
4 tips for investing in zero-coupon bonds
- Consider your financial goals. The biggest thing to remember about zero-coupon bonds is that they’re intended to be long-term investments that don’t necessarily offer cash in the near term, unless there’s sufficient market liquidity to sell them. Take the time to think about what your current financial situation is including your risk tolerance, time horizon and long-term goals.
- Understand the tax implications. The Internal Revenue Service considers the interest earned over time on zero-coupon bonds as taxable income, so although you won’t be getting paid a coupon you’ll need to be prepared for the tax liability, even if you’re holding zeros in a tax-advantaged account.
- Research the issuer’s credit quality. As with purchasing any bond, zero-coupon bonds are only as safe as the borrower’s ability to repay the investor. Government-backed zero-coupon bonds — like STRIPS — are often considered safest.
- Don’t make zero-coupon bonds your only investment. Zero-coupon bonds can be beneficial for a long-term goal, but should be balanced with other types of investments, such as equities, or bonds that pay interest.
Bottom line
Zero-coupon bonds pay no interest over time but are sold at a discounted face value. Zeros may be a good option for investors looking to meet a financial goal down the road, as they lock in a set return for a specified period in time. They may not be the best option if you find yourself wanting access to liquidity in a short period of time, though some investors choose to sell the bonds in highly liquid markets if the demand for zero-coupon bonds is present.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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