What Is a Zero-Coupon Bond?

A zero-coupon bond is an investment in debt that doesn't pay interest. It instead trades at a deep discount. The profit is realized at its maturity date when the bond is redeemed for its full face value.

A zero-coupon bond is al꧃so known as an accrual bond.

The Basics of Zero-Coupon Bonds

Some bonds are issued as zero-coupon instruments. Others are transformed into zero-coupon instruments𒈔 𝓡after a financial institution strips them of their coupons and repackages them as zero-coupon bonds.

They offer payment at face value at maturity so zero-coupon bonds tend to fluctuate in price on the secondary market much more than 澳洲幸运5官方开奖结果体彩网:coupon bonds.

What Is a Bond?

A bond is a tool for a company or a government to borrow money. Investors who purchase bonds are effectively acting as lenders to the issuing entity. The investors earn a return in the form of 澳洲幸运5官方开奖结果体彩网:coupon payments that are made semiannually or annually throughout the life of the bon🐠d.

The bondholder is repaid an amount equal to the 澳洲幸运5官方开奖结果体彩网:face value of the bond when the 澳洲幸运5官方开奖结果体彩网:bond matures. The par or face value of a corporate bonꦉd is typically stated as $1,000.

Investors can purchase the bond below its par value if a corporate bond is issued at a discount. An investor who purchases a bond for $920 at a discount will receive $1,000 when it reaches its maturity date. The $80 return plus coupon payments are the investor's earnings for holding the bond.

Not all bonds have cou💦pon payments, however. T⛎hose that do not are referred to as zero-coupon bonds.

How Zero-Coupon Bonds Work

Zero-coupon bonds are issued at a deep discount, and they 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.

The interest earned on a zero-coupon bond is an 澳洲幸运5官方开奖结果体彩网:imputed interest. It's an estimated interest rate for the bond and not an established interest rate. A bond with a face value of $20,000 that matures in 20 years with a 5🐼.5% yield may be purchased for roughly $6,855. The investor will receive $20,000 at the end of the 20 years.

The difference between $20,000 and $6,855 is $13,145. This represents the 澳洲幸运5官方开奖结果体彩网:interest that compounds automatically until the bond matures. Im🥃puted interest is sometimes referre🎀d to as "phantom interest."

The imputed interest on the bond is subject to federal 澳洲幸运5官方开奖结果体彩网:income tax. No coupon payments are made on zero-coupon bonds until maturity but investors may still have to pay federal, state, and local income taxes on the imputed interes🎉t that accrues each year.

Purchasing a municipal zero-coupon bond, buying zero-coupon bonds in a tax-exempt account, or purchasing a corporate zero-coupon bond that has tax-exempt status are a few ways to avoid paying income taxes on these securities.

Pricing a Zero-Coupon Bond

The price of a zero-coupon bond c🌸an be calcul⛎ated like this:

Price = M ÷ (1 + r)ⁿ

where:

• M = Maturity value or face value of the bond
• r = required rate of interest
• n = number of years until maturity

An investor would be willing to pay the following if they wanted to make a 6% return on a bond with a $25,000 par value that's due to mature in three years:

$25,000 / (1 + 0.06)³ = $20,991.

The bond would be sold to the investor at $20,991 / $25,000 = 84% of the face value if the debtor accepted this offer. The investor gains $25,000 - $20,991 = $4,009 at maturity. This translates to 6% interest per year.

The maturity dates on zero-coupon bonds are usually long-term with initial maturities of at least 10 years. These long-term maturity dates let investors plan for long-range goals such as saving for a child’s college education. An investor can put up a small amount of money that grows over time with the bond's deep discount.

Zero-coupon bonds can be issued from a variety of sources including the U.S. Treasury, state and local government entities, and corporations. Most zero-coupon bonds trade on the major exchanges.

The Bottom Line

Zero-coupon bonds are an alternative to better-known coupon bonds that pay regular interest to their investors. Zero-coupon bonds pay no interest, but they're purchased at a deep discount and repaid at full price.

Most zero-coupon bonds are long-term issues. Ten or more years is common. They're often used to finance a long-range goal such as paying for a child's college education.

One big thing to consider: The owners of zero-coupon bonds pay a "phantom interest" tax on the bonds' earnings through the years they hold them.