The difference between a regular bond and a zero-coupon bonds, is that the former pays bondholders interest, while the latter does not issue such interest payments, otherwise known as coupons. Instead, zero-coupon bondholders merely receive the face value of the bond when it reaches maturity, while coupon paying bondholders receive both the face value, while also receiving coupons, over the life of the bond.
A Closer Look at the Differences
Zero-coupon bondholders gain on the difference between the price they pay for the bond and the amount they will receive at the bond's maturity. This can be substantial, because zero-coupon bonds are typically purchased at drastically reduced prices, known as deep discounts, to the bond’s face value. In other words, a zero-coupon bondholder derive financial gain from the difference between the bond’s purchase price and its face value, while the coupon bondholders profit from the regular distribution of interest payments.
Regular bonds pay bondholders interest payments throughout the lives of the bonds, while zero-coupon bonds do not issue such interest payments, which are otherwise known as coupons.
Imagine you are presented with a choice. On one hand, you may invest in a one-year zero-coupon bond with a face value of $1,000, which can be purchased for $952.38. On the other hand, you may invest in a one-year 5% semi-annual coupon bond, that trades at its $1,000 face value. 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). However, if you bought the coupon bond, you would have received two coupon payments of $25 during the year, for a total of $50, which also represents a 5% gain ($50/$1,000). In this case, both bonds options will usher in the exact same profits, even though the source of the returns are different. It should be noted, that this symmetry is an unusual circumstance.
Making Money on a Zero-Coupon Bond
The length of time it takes for zero-coupon bonds to reach maturity depends on whether the bond in question is a short-term or long-term investment. While short-term zero-coupon bonds, usually called bills, generally mature in less than one year, long-term investments generally have maturity dates beginning 10 to 15 years after the bond is purchased. This means that holders of the latter instruments won’t see profits for at least a decade. For this reason, it makes little sense for retired investors seeking steady income flows, to engage in long-term zero-coupon bond investments.
Contrarily, a family saving for a vacation retirement home may greatly benefit from investing in a zero-coupon bond with a 15- or 20-year maturity. Zero-coupon bonds may also appeal to investors looking to pass wealth onto theirs. For example, if a $2,000 bond gifted, the giver uses only $2,000 of his or her yearly gift tax exclusion, while the recipient ultimately receives substantially more than $2,000, after the bond reaches maturity.
Because zero-coupon bonds do not pay regular interest, they are sold at a discount in the market.
Zero-coupon bonds issued in the U.S. retain an original issue discount, or OID, for tax reasons. Such bonds often input receipt of interest payment, or phantom income, even though they don’t pay out periodic interest. Consequently, zero-coupon bonds subjected to taxation in the U.S. can be held in a tax-deferred retirement account, letting investors avoid paying tax on future income. Alternatively, if a zero-coupon bond is issued by a U.S. local or state government entity, which is the case with municipal bonds, any imputed interest is free from U.S. federal tax and typically state and local tax as well.