At first blush, the idea of a bond that doesn't pay interest seems oxymoronic. After all, isn't a bond a debt instrument that pays periodic interest and repays the principal at maturity?
Zero coupon bonds are indeed debt instruments but are issued at a discount to their face value, make no interest payments, and pay its face value at time of maturity.
How's it Work?
Let's say a hypothetical zero coupon bond is issued today at a discount price of $743 with a face value of $1,000, payable in 15 years. If you buy this bond, hold it for the entire term and receive the face-value payment, the difference of $257 represents the interest you earned. In this hypothetical example, the bond's interest rate would amount to approximately 2%.
Zero coupon bonds are predominantly issued by the Federal government and typically, they are issued with maturities of 10 to 15 years.
Zero coupon bonds are traded on recognized financial markets and exchanges, which may offer investors liquidity in the event they choose not to hold them to maturity.
Price Swings
One of the biggest risks of zero coupon bonds is their sensitivity to swings in interest rates. In a rising interest rate environment, their value is likely to fall more than other bonds.
Zero coupon bonds are subject to an unusual taxation in which the receipt of interest is imputed each year, requiring holders to pay income taxes on what is called "phantom income."
Target Dates
For individuals, zero coupon bonds may serve several investment purposes. Zeros may be bought to fund specific future financial obligations, for example, college savings. By placing them in a U.S. Treasury zero, a parent can be assured that the funds will be fully intact to meet this liability.
As with any investment, a zero coupon bond's appropriateness hinges on your individual needs and circumstances. Understanding some of the basic concepts may help you better assess whether they might have a place in your portfolio.