A zero-coupon bond is a type of debt investment that doesn’t give you interest payments. Instead, it sells for a much lower price than its actual value. You make your profit when it matures and you cash it in for the full amount. It’s also called an accrual bond.
Learn more about Zero-Coupon Bonds
Some bonds come out as zero-coupon types, while others get turned into zero-coupon bonds when a financial institution removes their coupons and repackages them. They pay out the face value at maturity, which is why zero-coupon bonds usually see more price swings in the secondary market compared to coupon bonds.
How Zero-Coupon Bonds Work?
Zero-coupon bonds are sold at a significant discount and pay back their full value when they mature. The profit for the investor comes from the difference between what they paid and the amount they receive at maturity.
Essentially, the investor gets back their initial investment plus the interest that has been compounded semiannually based on a specified yield. The interest on these bonds is considered imputed interest, which is a projected rate rather than a fixed one.
For example, a bond worth $20,000 that matures in 20 years with a 5.5% yield can be bought for about $6,855, meaning the investor will get $20,000 back after 20 years. The $13,145 difference is the interest that builds up over time until maturity, and this imputed interest is sometimes called ‘phantom interest.’ It’s important to note that this imputed interest is taxable at the federal level.
While zero-coupon bonds don’t make any coupon payments until they mature, investors might still owe federal, state, and local taxes on the imputed interest that accumulates each year.
To avoid these taxes, one could consider buying municipal zero-coupon bonds, investing in tax-exempt accounts, or opting for corporate zero-coupon bonds that have tax-exempt status.
Valuing a Zero-Coupon Bond
You can figure out the price of a zero-coupon bond this way:
Price = M ÷ (1 + r)^nwhere:
- M = Maturity value or face value of the bond
- r = required rate of interest
- n = number of years until maturity
If an investor is looking to earn a 6% return on a bond worth $25,000 that matures in three years, here’s what they’d be ready to pay:
$25,000 / (1 + 0.06)^3 = $20,991.If the debtor agrees to the offer, the bond will be sold to the investor for $20,991, which is 84% of its face value of $25,000. This means the investor will make $4,009 when the bond matures, equating to an annual interest rate of 6%. Zero-coupon bonds typically have long-term maturity dates, often starting at 10 years or more, allowing investors to save for big goals like their kid’s college fund. With a small initial investment, the bond’s significant discount helps the money grow over time. These bonds can come from various sources, including the U.S. Treasury, state and local governments, and corporations, and most of them are traded on major exchanges.
Conclusion
Zero-coupon bonds are a different option compared to the more familiar coupon bonds that give regular interest payments. Instead of paying interest, zero-coupon bonds are bought at a significant discount and then paid back at their full value.
Most of these bonds are long-term, typically lasting ten years or more, and are often used to fund long-term goals like saving for a child’s college tuition.
One important thing to keep in mind is that holders of zero-coupon bonds have to pay taxes on ‘phantom interest’ based on the earnings while they own the bonds.