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What is Zero Coupon Bond?

written by: Tim Plaehn•edited by: Rebecca Scudder•updated: 3/1/2011

Investing in Zero Coupon Bonds, bought at a heavy discount to their face value, can be a safe and assured method of organizing funds for future financial spending.

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    Types Of Bonds

    Bonds are debt securities issued by governments and corporations. The typical bond pays interest -- the coupon -- twice a year and the investor gets back the face amount of a bond when it matures. A zero coupon bond, as the name implies, does not pay regular interest payments to investors.

    The most common form of zero coupon bonds are Treasury STRIPS. These are U.S. Treasury bonds where the interest payments are "stripped" away and sold to investors as future principal payments. So how does an investor earn money from bonds with no coupon payments? Read on!

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    Zero Coupon Bonds

    Zero coupon bonds, also known as discount bonds, may be defined as bonds that do not pay interest during the tenure of the bonds. Instead, investors can purchase the zero coupon bonds at a much lower price than their face value. When a zero coupon bond matures, the investor will receive the face value, which is higher than the price it was originally bought at.

    The maturity dates on zero coupon bonds can be set at various lenghts, but generally, the period of maturity is over fifteen years. These long-term maturity dates do have advantages, as the investor can plan for some long-term money requirement like a child’s higher education or post-retirement spending.

    The investor has the option to hold on to the bonds until maturity or sell it at any time in the secondary markets. Prices of zero coupon bonds are often volatile in the secondary market and fluctuate sharply compared with other types of bonds. Financial analysts say that the advantage of zero coupon bonds lies in retaining them till maturity instead of off-loading in the secondary market. If for whatever reasons, the investor decides to sell a zero coupon bond, its value will be determined by prevailing market prices, years remaining for maturity and credit worthiness of the bond issuer.

    It is important to note that with zero coupon bonds the investor has to pay federal, state, and local income taxes on the notional interest that accrues each year, even though the interest payment is actually received only on maturity. Some investors overcome this tax burden by purchasing municipal zero coupon bonds or buying them inside of tax-advantaged accounts.

    There is an inherent threat that the issuer may not provide payment when the bond matures. This risk factor is almost zero if the bonds has been issued by federal or state governments or other government bodies, as the credibility of the concerned government is at stake. The risk factor is real if the issuer is a private organization.

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    Treasury STRIPS

    Teasury bond STRIPS are formed when the interest payments and final principal payment of a Treasury bond are sold as separate future payment obligations of the U.S. Treasury. STRIPS are only offered through commercial brokers and dealers and not directly by the Treasury to individual investors. Treasury zero coupon bonds are the most widely available zeros, and have the full backing of the U.S. government.

    Current prices and yields for STRIPS can be found in the Market Data section of the Wall Street Journal. The WSJ has listings for both stripped principal bonds and stripped interest bonds. STRIPS can be purchased with maturities in February, May, August or November out to 30 years in the future. Some example prices and rates effective in January 2011 were:

    • Treasury bond principal STRIP maturing November, 2040: Price: 24.251, yield 4.80%.
    • Treasury interest STRIP for August, 2016: Price: 87.839, yield 2.33%.

    The price is the percentage of the face amount of the bond to be received at maturity. For example, a $100,000 STRIP maturing in 2040 would cost $24,251.

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    References

    SEC: Zero Coupon Bonds: http://www.sec.gov/answers/zero.htm

    Treasury Direct: STRIPS http://www.treasurydirect.gov/instit/marketables/strips/strips.htm