The One-Minute Guide to Zero Coupon Bonds (2024)

FAQs

What is a zero coupon bond for dummies? ›

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond "matures" or comes due.

Because of their sensitivity to interest rates, zero-coupon Treasury bonds have incredibly high interest rate risk. Treasury zeros fall significantly if the Fed raises interest rates. They also have no interest payments to cushion a fall. Zero-coupon U.S. Treasury bonds have a poor risk-return profile when held alone.

If interest rates rise, the value of your zero coupon bond on the secondary market will likely fall. Long-term zeros can be particularly sensitive to changes in interest rates, exposing them to what is known as duration risk. Also, zeros may not keep pace with inflation.

These bonds are issued at a deep discount and repay the par value, at maturity. The difference between the purchase price and the par value represents the investor's return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.

Depending on the issuer, zero-coupon municipal bonds may generate tax-free imputed income, which means you won't have to pay tax until the bond matures -- usually many years in the future. Corporate zeros, on the other hand, usually will lead to some annual tax liability even if you don't receive any interest in cash.

A zero-coupon bond is a bond that pays no interest and trades at a discount to its face value. It is also called a pure discount bond or deep discount bond. U.S. Treasury bills are an example of a zero-coupon bond.

Zero-coupon bonds are often perceived as long-term investments, although one of the most common examples is a “T-Bill,” a short-term investment. U.S. Treasury Bills (or T-Bills) are short-term zero-coupon bonds (< 1 year) issued by the U.S. government.

In the U.S., zero-coupon bonds create a tax liability for interest payments, even though they don't actually pay periodic interest. That creates a phantom income problem for the bondholders. 1 It can be challenging to come up with the money to pay taxes on income that was not received.

What Type of Interest Payments Are Earned on a Treasury Bill? The only interest paid will be when the bill matures. At that time, you are given the full face value. T-bills are zero-coupon bonds usually sold at a discount, and the difference between the purchase price and the par amount is your accrued interest.

No reinvestment risk: Other coupon bonds don't let investors to a bond's cash flow at the same rate as the investment's required rate of returns. The Zero Coupon bonds eliminate the reinvestment risk.

What is the credit risk of a zero-coupon bond? ›

Investors in zero-coupon bonds are exposed to the credit risk of the issuer, which may default on its obligation to repay the bond's face value upon maturity.

A bond with a coupon rate of zero, therefore, is one that pays no interest.

Notified zero coupon bonds issued by REC and NABARD are taxable. Gains from zero coupon bonds are subject to capital gains tax on maturity. The capital appreciation for zero coupon bonds is the difference between the maturity price and purchase price of the bond.

Zeros, as they are sometimes called, are bonds that pay no coupon or interest payment. With a conventional bond, you can typically expect to receive a coupon payment every six months. Zero-coupon bonds, on the other hand, credit you with interest but don't actually pay any until maturity.

A popular zero coupon bond is Separate Trading of Registered Interest and Principal Securities, or STRIPS. The U.S. Treasury doesn't sell STRIPS, but other financial institutions or government securities brokers or dealers can convert a Treasury security into a STRIP bond, or when a bond is stripped of its interest.

Zeros, as they are sometimes called, are bonds that pay no coupon or interest payment. With a conventional bond, you can typically expect to receive a coupon payment every six months. Zero-coupon bonds, on the other hand, credit you with interest but don't actually pay any until maturity.

Treasury bills are also known as zero coupon bonds, meaning unlike bonds and notes, they don't pay a fixed interest rate. Instead, Treasury bills are sold at a discount rate to their face value.

Investment amount: CDs typically require a minimum investment and have a fixed term, whereas zero coupon bonds can be purchased in any denomination and have no set maturity date. Price fluctuation: The price of a zero coupon bond can fluctuate, whereas the price of a CD is fixed and does not change.

A strip bond is a debt instrument in which both the principal and regular coupon payments—which have been removed—are sold separately. A strip bond is also known as a zero-coupon bond.