1. 20 Investments: Introduction
  2. 20 Investments: American Depository Receipt (ADR)
  3. 20 Investments: Annuity
  4. 20 Investments: Closed-End Investment Fund
  5. 20 Investments: Collectibles
  6. 20 Investments: Common Stock
  7. 20 Investments: Convertible Security
  8. 20 Investments: Corporate Bond
  9. 20 Investments: Futures Contract
  10. 20 Investments: Life Insurance
  11. 20 Investments: The Money Market
  12. 20 Investments: Mortgage-Backed Securities
  13. 20 Investments: Municipal Bonds
  14. 20 Investments: Mutual Funds
  15. 20 Investments: Options (Stocks)
  16. 20 Investments: Preferred Stock
  17. 20 Investments: Real Estate & Property
  18. 20 Investments: Real Estate Investment Trusts (REITs)
  19. 20 Investments: Treasuries
  20. 20 Investments: Unit Investment Trusts (UITs)
  21. 20 Investments: Zero-Coupon Securities
  22. 20 Investments: Conclusion

What Is It?
A zero-coupon security, or "stripped bond", is basically a regular coupon-paying 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 zero-coupon bonds or "zeros".

You can think of a zero-coupon security just like a T-bill. 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 zero-coupon 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 zero-coupon 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
Zero-coupon securities can be bought through most full service or discount brokers, commercial banks, and some other financial intermediaries.

Strengths

  • Zeros can be bought at huge discounts.
  • Once you buy a zero-coupon security, you essentially lock in the yield to maturity.

  • Weaknesses
  • If the company issuing the zero goes bankrupt or defaults, then you have everything to lose. Whereas, with a regular coupon bond, you may have at least gotten some interest payments out of the investment.
  • Interest earned on the zero-coupon bond is taxed as income (a higher rate) rather than capital gains.

  • Three Main Uses
  • Capital Appreciation
  • Tax-Deferred Savings
  • Predictability

  • 20 Investments: Conclusion
    Related Articles
    1. Investing

      What are Treasury STRIPS?

      STRIPS is an acronym that stands for Separate Trading of Registered Interest and Principal Securities.
    2. Investing

      How Are Zero-Coupon Municipal Bonds Taxed?

      What every investor needs to know about taxes and zero-coupon muni bonds.
    3. Investing

      Introduction To STRIPS

      STRIPS provide an alternative form of bond for fixed-income investors who need definite cash flows at specific times. Read the article to find out how.
    4. Investing

      Corporate Bonds: Advantages and Disadvantages

      Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
    5. Investing

      Understanding Bond Prices and Yields

      Understanding this relationship can help an investor in any market.
    6. Investing

      Risks To Consider Before Investing In Bonds

      Make sure you understand the risks associated with bonds before making an investment decision.
    Frequently Asked Questions
    1. Where else can I save for retirement after I max out my Roth IRA?

      The first option to explore is to determine if you can contribute to a 401(k), 403(b), or 457 plan at work. If your employer ...
    2. How did George Soros "break the Bank of England"?

      In Britain, Black Wednesday (September 16, 1992) is known as the day that speculators broke the pound. They didn't actually ...
    3. What counts as "debts" and "income" when calculating my debt-to-income (DTI) ratio?

      It's important to know your debt-to-income ratio because it's the figure lenders use to measure your ability to repay the ...
    4. Who are Monsanto's main competitors?

      Learn about Monsanto Company's two main operating divisions and its main competitors within each sector, including The Mosaic ...
    Trading Center