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What is a 'Zero-Coupon Bond'

A zero-coupon bond, also known as an "accrual bond," is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

Some zero-coupon bonds are issued as such, while others are bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price much more than coupon bonds.

BREAKING DOWN 'Zero-Coupon Bond'

When a zero coupon bond matures, the investor receives one lump sum equal to the initial investment plus the imputed interest.

The maturity dates on zero coupon bonds are usually long term, with many having initial maturities of at least 10 years. These long-term maturity dates can allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the bond's deep discount, an investor can put up a small amount of money that can grow over many years.

Investors can choose zero coupon bonds that are issued from a variety of sources, including the U.S. Treasury, state/local government entities, and corporations.

Example

Most bonds provide semiannual interest payments, while zero coupon bonds do not pay cash coupons. Rather, the investor receives one payment at maturity which is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. Zero coupon bonds credit investors with regular interest although the cash coupon is not paid until maturity.

Zero coupon bonds are sold at a substantial discount from the face amount. For example, a bond with a face amount of $20,000 maturing in 20 years with a 5.5% yield may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,757 represents the interest that compounds automatically until the bond matures,

Other Factors

Prices fluctuate more than with other types of bonds in the secondary market because zero coupon bonds pay no interest until maturity. In addition, although no coupon payments are made on zero coupon bonds until maturity, investors may still have to pay federal, state and local income taxes on the imputed or phantom interest 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 have tax-exempt status may be one way to avoid paying income taxes.

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