Loading the player...
A:

The difference between a zero-coupon bond and a regular bond is that a zero-coupon bond does not pay coupons or interest payments to the bondholder, while a typical bond does make these interest payments.

The holder of a zero-coupon bond only receives the face value of the bond at maturity. The holder of a coupon paying bond receives the face value of the bond at maturity but is also paid coupons over the life of the bond.

The Breakdown

Zero-coupon bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity. Zero-coupon bonds are purchased at a large discount, known as deep discount, to the face value of the bond.

A coupon-paying bond will initially trade near the price of its face value. In other words, a zero-coupon bond gains from the difference between the purchase price and the face value, while the coupon bond gains from the regular distribution of interest.

For example, imagine that you have the choices between a one-year zero-coupon bond with a face value of $1,000, which can be purchased for $952.38 or a one-year 5% semi-annual coupon bond trading at its face value of $1,000. If you bought the zero-coupon bond for $952.38, you would receive $1,000 at maturity, which is a gain of 5% ($47.62/$952.38). If you bought the coupon bond, you would have received two coupon payments of $25 each during the year for a total of $50, which also represents a 5% gain ($50/$1,000).

So, in this case, no matter which bond you buy, you will get the same return, even though the source of the return is different. This is not always true, as each case is different.

Making Money on a Zero-Coupon Bond

As noted above, an investor makes money on a zero-coupon bond by being paid interest upon maturity.

The amount of time involved for a zero-coupon bond to reach maturity depends on whether the bond is a short-term or long-term investment. A zero-coupon bond that is a long-term investment generally has a maturity date that starts around 10 to 15 years.

Zero-coupon bonds that are considered short-term investments typically have a maturity that is no more than one year. Such short-term bonds are usually called bills. Because zero-coupon bonds return no interest payments throughout the maturation process – for example, 17 years – investors in the bond do not see any profit for nearly two decades.

Why It Matters

For instance, a retired investor seeking to maintain a steady flow of income sees little use for zero-coupon bonds. However, a family saving to buy a vacation retirement home could benefit significantly from a zero-coupon bond with a 15- or 20-year maturity. A zero-coupon bond may also appeal to an investor seeking to pass on wealth to his heirs.

If a $2,000 bond is given as a gift, the giver uses only $2,000 of his yearly gift tax exclusion, and the recipient receives more than $2,000 once the bond reaches maturity.

Zero-coupon bonds issued in the U.S. retain an original issue discount, or OID, for tax reasons. Zero-coupon bonds often input receipt of interest payment, or phantom income, despite the fact the bonds do not pay periodic interest.

For this reason, zero-coupon bonds subjected to taxation in the U.S. can be held in a tax-deferred retirement account, allowing investors to avoid paying tax on future income. As an alternative to this process, if a zero-coupon bond is issued by a U.S. local or state government entity such as in the case of a municipal bond, any imputed interest is free from U.S. federal tax and typically state and local tax as well.

RELATED FAQS
  1. How does an investor make money on bonds?

    Bonds are part of fixed-income securities called debt obligations, meaning one party borrows from another party who expects ... Read Answer >>
  2. How do I calculate yield to maturity of a zero-coupon bond?

    Find out how to calculate the yield to maturity of a zero-coupon bond, and learn why this calculation is simpler than one ... Read Answer >>
  3. What are the different types of college savings accounts?

    Find out more about the Macaulay duration and zero-coupon bonds and how to calculate the Macaulay duration of a zero-coupon ... Read Answer >>
  4. How are municipal bonds taxed?

    Discover information about the various tax implications for municipal bonds and zero-coupon municipal bonds at the state ... Read Answer >>
Related Articles
  1. Investing

    Advantages and Risks of Zero Coupon Treasury Bonds

    Zero coupon bonds are bonds that do not make any interest payments until maturity, you won't put a single penny of interest in your pocket for two decades.
  2. Investing

    Corporate Bonds: Advantages and Disadvantages

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

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  4. Investing

    A Guide to High Yield Corporate Bonds

    The universe of corporate high yield bonds encompasses multiple different types and structures.
  5. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  6. Investing

    6 Ways That Investors Use Bonds

    Learn how the stodgy stereotype of bonds can overshadow the basic and advanced uses of what these investments can do for your portfolio.
  7. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  8. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
RELATED TERMS
  1. Zero-Coupon Bond

    A zero-coupon bond is a debt security that doesn't pay interest ...
  2. Zero-Coupon Convertible

    A zero-coupon convertible is a fixed income instrument that combines ...
  3. Coupon Stripping

    Coupon stripping is the separation of a bond's periodic interest ...
  4. Bond Valuation

    Bond valuation is a technique for determining the theoretical ...
  5. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  6. Deep-Discount Bond

    A deep-discount bond is a bond that sells at a significant lesser ...
Trading Center