Zero coupon bonds exist because a financial institution has taken a regular bond and created a "zero." Most other bond types differed by issuer.
This bond type is issued by many financial entities, but because it is so different from traditional bonds, it is set apart. Zero coupon bonds, or zeros, pay no regular interest.
You buy the bond at a deep discount and redeem it at full face value, receiving all the interest in one lump sum when the bond matures. The difference is the interest that has accumulated over the years.
Zero coupon bonds come in maturities from one to forty years. The U.S. Treasury issues are the most popular zeros, although zeros are offered for both municipal and corporate bonds.
Here are some general characteristics of zero coupon bonds:
- Issued at deep discount and redeemed at full face value
- Some issuers may call zeros before maturity
- You must pay tax on interest annually even though you don't receive it until maturity
Treasury bonds are the most popular. However, the U.S. Treasury doesn't issue them directly; you buy "STRIPS" from qualified financial institutions or brokers.
STRIPS stands for Separate Trading of Registered Interest and Principal of Securities and it means a financial institution has taken a regular U.S. Treasury issue and separated the principal and interest payments into two separate securities.
The normal income is packaged into a separate security and sold to investors who need a reliable cash flow and the principal becomes a zero coupon bond.
Although you buy the STRIP (they come in other names also) from brokers and financial institutions, they still carry the full faith and credit of the U.S. government. Municipalities and corporations also issue zero coupon bonds. They are also sold at a deep discount and redeemed in the future at full face value.
However, some of these issues may have call features allowing the issuer to redeem them before maturity. Be sure to check for those provisions before you invest. Municipal zero coupon bonds are exempt from federal income tax like regular municipal bonds.
The major credit agencies rate most zero-coupon bonds for credit worthiness. This rating can change during the life of the bond, which can affect the price.
There is a secondary market for zero coupon bonds, although not as robust as for regular bonds. If you need to get rid of a zero coupon bond, its value will be determined by prevailing market rates, years remaining, and credit worthiness of issuer.
The advantage of zero coupon bonds is in keeping them until maturity. Many investors use them to provide a solid base against a volatile stock market.
For example, suppose you had $100,000 to invest. You might take $25,000 or so and buy a $100,000 STRIP (U.S. Treasury issue) maturing in 20 years. You might then take the remaining $75,000 and invest it in stocks appropriate for your financial goals.
The worst that can happen is in 20 years you'll get your money back (redeem bond at $100,000 face value). (Fees and taxes would have to be paid.)
Zero coupons are taxed just like regular bonds even though they don't pay interest until maturity. Every year the issuer will send a statement telling you how much interest accrued to the bond that year. There are some things you can do to offset the tax on "phantom" interest.
Municipal zero coupon bonds are free of federal income tax and may be free of state and local tax where issued, but are difficult to find. Zero coupon bonds work best in retirement accounts where they can grow free from tax on current interest.