The difference between a regular bond and a zero-coupon bond is the payment of interest, otherwise known as coupons. A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments. Instead, zero-coupon bondholders merely receive the face value of the bond when it reaches maturity. Regular bonds, which are also called coupon bonds, pay interest over the life of the bond and also repay the principal at maturity.

KEY TAKEAWAYS

  • A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments.
  • A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve.
  • Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated short-term price movements.
  • Zero-coupon bonds can help investors to avoid gift taxes, but they also create phantom income tax issues.

The Difference for Investors

Long-term zero-coupon bond investors gain the difference between the price they pay for the bond and the amount they receive at the bond's maturity. This amount can be substantial because zero-coupon bonds are typically purchased at deep discounts to the bond’s face value. This discount frequently leads to higher returns in the long-run.

A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. With a normal yield curve, long-term bonds have higher yields than short-term bonds. The interest payments made by regular coupon bonds are due before the date of maturity, so those payments are like small zero-coupon bonds that mature earlier. Interest payments cut down the wait time and the risk, so they also reduce expected returns.

The absence of coupons does not make zero-coupon bonds bad investments, and they usually offer better returns than coupon bonds.

The Difference for Speculators

Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated short-term price movements. All other things being equal, the price of a zero-coupon bond will increase more than the price of a regular coupon bond when interest rates fall. Because U.S. Treasury bond prices respond strongly to interest rate changes, zero-coupon Treasuries are preferred for speculating on interest rates.

Zero-coupon corporate bond prices are also volatile, so they can be used for speculating on the health of the issuing company. Suppose that a company facing bankruptcy previously issued zero-coupon and coupon bonds that both mature in five years. The market price of both bonds would have plummeted, with the result that the coupon bonds now pay very high interest relative to their purchase price. That creates a cushion if the company should go bankrupt before maturity. The zero-coupon bond has no such cushion, faces higher risk, and makes more money if the issuer survives.

Zero-Coupon Bonds and Taxes

Zero-coupon bonds may also appeal to investors looking to pass on wealth to their heirs. If a bond selling for $2,000 is received as a gift, it only uses $2,000 of the yearly gift tax exclusion. However, the recipient ultimately receives substantially more than $2,000 after the bond reaches maturity. Unfortunately for zero-coupon bondholders, some taxes can reduce the effectiveness of this strategy.

In the U.S., zero-coupon bonds create a tax liability for interest payments, even though they don’t actually pay periodic interest. That creates a phantom income problem for the bondholders. It can be challenging to come up with the money to pay taxes on income that was not received.

Consequently, it is often a good idea to hold zero-coupon bonds in a tax-deferred retirement account to avoid paying tax on future income.

A zero-coupon bond issued by a U.S. local or state government entity is another alternative. All interest on these municipal bonds, including imputed interest for zero-coupon bonds, is free from U.S. federal taxes. Municipal bonds are often free from state and local taxes as well.