Loading the player...

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.

RELATED TERMS
  1. Coupon Rate

    The yield paid by a fixed income security. A fixed income security's ...
  2. Coupon Bond

    A debt obligation with coupons attached that represent semiannual ...
  3. Current Coupon Bond

    A bond with a coupon rate that is within 0.5\% of the current ...
  4. Coupon Stripping

    The separation of a bond's periodic interest payments from its ...
  5. Bond

    A debt investment in which an investor loans money to an entity ...
  6. Coupon

    The annual interest rate paid on a bond, expressed as a percentage ...
Related Articles
  1. Personal Finance

    ‘Retired’ Too Soon? How to Reenter the Workforce After 50

    Here's what you need to know to survive financially and reenter the workforce when you're over 50 and a layoff has forced you to "retire" too soon.
  2. Financial Advisor

    Using Excel PV Function to compute Bonds PV

    To determine the value of a bond today - for a fixed principal (par value) to be repaid in the future at any predetermined time - we can use an Excel spreadsheet.
  3. Investing

    How Does A Bond’s Coupon Interest Rate Affect Its Price?

    All bonds come with a coupon interest rate, which is the fixed annual interest a bond pays.
  4. Investing

    Explaining the Coupon Rate

    Coupon rate is the stated interest rate on a fixed income security.
  5. Investing

    What is a "Coupon"?

    In the financial world, “coupon” represents the interest rate on a bond.
  6. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  7. Financial Advisor

    Simple Math for Fixed-Coupon Corporate Bonds

    A guide to help to understand the simple math behind fixed-coupon corporate bonds.
  8. Investing

    An Introduction to Individual Bonds

    Individual bonds are better than bond funds and can be a key component to one’s investment strategy.
  9. Personal Finance

    Coupon Shopping: Clip Your Way To Savings

    Use coupons strategically to score big savings on everyday purchases.
RELATED FAQS
  1. How do debit spreads impact the trading of options?

    Find out what it means when a bond has a coupon rate of zero and how a bond's coupon rate and par value affect its selling ... Read Answer >>
  2. How do I calculate yield to maturity of a zero coupon bond?

    Find out how to calculate the yield to maturity for a zero coupon bond, and see why this calculation is more simple than ... Read Answer >>
  3. Why do zero coupon bonds tend to be volatile?

    Learn why the price of zero coupon bonds is volatile and why some investors may wish to hold them in retirement accounts ... Read Answer >>
  4. How does a bond's coupon rate affect its price?

    Find out how a bond's coupon rate influences its price, including the role of government-dictated interest rates and the ... Read Answer >>
  5. What is the difference between yield to maturity and the coupon rate?

    A bond's coupon rate is the actual amount of interest income earned on the bond each year based on its face value. The yield ... Read Answer >>
Hot Definitions
  1. Leveraged Buyout - LBO

    The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. ...
  2. Current Assets

    A balance sheet account that represents the value of all assets that can reasonably expected to be converted into cash within ...
  3. Tax Liability

    The total amount of tax that an entity is legally obligated to pay to an authority as the result of the occurrence of a taxable ...
  4. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  5. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  6. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
Trading Center