20 Investments: ZeroCoupon Securities
What Is It?
A zerocoupon security, or "stripped bond", is basically a regular couponpaying bond without the coupons. The process of "stripping" or "zeroing" a bond is usually done by a brokerage or a bank. The bank or broker stripping the bonds then registers and trades these zeros as individual securities.
Once the bonds are stripped, there are two parts: the principal and the coupons. The interest payments are known as "coupons", and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are bundled and referred to as zerocoupon bonds or "zeros".
You can think of a zerocoupon security just like a Tbill. Basically, you pay a certain amount right now in exchange for the par value of the security at a future date, usually $1,000. For example, you might pay $800 for a zerocoupon bond today and in five years you will receive the par value of $1,000. The longer the time to maturity, the cheaper you can buy the bond for. This predictability also makes zeros popular  when you buy the security, the yield is essentially locked in.
Objectives and Risks
The basic objective of a zerocoupon security is "buy low, sell high". You purchase the bond for a sum of money, and once it reaches maturity you will be paid an even larger sum of money. When interest rates are low, the price of the zero will be higher. The best time to buy a zero is when interest rates are high because the bond will be at a deeper discount.
The one major problem with zeros is that the annual accumulated return is actually considered to be income, and while you don't actually collect that interest until the bond reaches maturity, you still have to pay income tax on it. In other words, the gains on a zero are not treated as capital gains, instead they are considered to be interest.
How To Buy or Sell It
Zerocoupon securities can be bought through most full service or discount brokers, commercial banks, and some other financial intermediaries.
Strengths

Weaknesses

Three Main Uses


Coupon Stripping
The separation of a bond's periodic interest payments from its ... 
ZeroCoupon Bond
A debt security that doesn't pay interest (a coupon) but is traded ... 
Strip
1. For bonds, the process of removing coupons from a bond and ... 
Strip Bond
A bond where both the principal and regular coupon paymentswhich ... 
Discount Bond
A bond that is issued for less than its par (or face) value, ... 
ZeroCoupon Convertible
A fixed income instrument that is a combination of a zerocoupon ...

How does an investor make money on a zero coupon bond?
Learn about investing in zerocoupon bonds, exactly how they work as an investment vehicle, and their advantages and disadvantages ... Read Answer >> 
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 >> 
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 >> 
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 >> 
What is the formula for calculating the capital to risk weight assets ratio for a ...
Learn about the Macaulay duration and zerocoupon bonds, the formula used for the calculation and how to calculate the Macaulay ... Read Answer >> 
How does the money from the interest on my bond get to me?
When you buy a regular coupon bond, you are entitled to a coupon, which is typically paid at regular intervals, and the face ... Read Answer >>