DEFINITION of 'Zero-Coupon Certificate Of Deposit (CD)'
A certificate of deposit (CD) that is purchased at a largely discounted rate. It differs from a traditional CD in that interest payments are not received yearly, but rather as a lump sum at the date of maturity.
BREAKING DOWN 'Zero-Coupon Certificate Of Deposit (CD)'
The advantage of a zero-coupon CD is that there is no reinvestment risk, unlike with an instrument that pays interest at regular intervals. The disadvantage to investors is that even though interest is not paid annually, it is deemed to have accrued annually and is treated as the investor's taxable income, which means that tax is payable every year on the accrued interest for the term of the CD.
While the interest is not received until the maturity date of the CD, taxes must be paid on the interest every year up until the interest is actually received. Even though the price of the CD is discounted to far below par to entice purchase, strong emphasis must be placed on ensuring that the buyer will have enough money to pay the large tax bill each year.