What are zero coupon bonds and why do people invest in them?

What is a Bond?

A bond is an obligation of a government, a company or an individual to pay a sum of money back to you at some time in the future, often with interest. Normally this sum would be repaid in small amounts on a regular basis, for example, a weekly payment.

A bond is a certificate of indebtedness that a government or company issues to borrow money. Bonds are usually issued with a maturity date, which is the date on which the bond will be repaid. The interest rate on a bond is the percentage of the principal that the borrower pays each year to the lender. Bonds are also referred to as fixed-income securities because their payments are fixed.

What are Zero Coupon Bonds?

Zero-coupon bonds are bonds that bear no interest for the duration of the bond’s existence. Rather than that, investors purchase zero-coupon bonds at a substantial discount to their face value or the amount the investor will receive when the bond “matures” or matures.

Buying zero-coupon bonds involve a risk premium because you don’t get any of the “safety” that is usually associated with investing in bonds.

Zero-coupon bonds typically have long maturity dates—many do not mature for ten, fifteen, or more years. These long-term maturity dates enable an investor to prepare for a long-term objective, such as financing a child’s college tuition. With the deep discount, an investor can invest a small sum that will grow over time.

Investors can acquire many types of zero-coupon bonds issued by a range of issuers, including the US Treasury, businesses, and state and local government bodies, in the secondary markets.

Because zero-coupon bonds pay no interest until maturity, their secondary market prices fluctuate more than other types of bonds. Additionally, even though zero-coupon bonds do not pay interest until they mature, investors may be subject to federal, state, and local income taxes on the imputed or “phantom” interest that accrues each year. Certain investors avoid paying tax on imputed interest by acquiring municipal zero-coupon bonds (assuming they reside in the state where the bond was issued) or the rare tax-exempt corporate zero-coupon bonds.

Why do People Invest in Zero Coupon Bonds, Anyway?

Zero coupon bonds are a low-risk investment because the issuer has less incentive to default. Investors typically buy zero coupon bonds because they provide a higher rate of return than traditional bonds. Issuers sell zero coupon bonds at a discount and investors receive the full face value when the bond matures. Zero coupon bonds are also less sensitive to interest rate fluctuations than traditional bonds.