The difference between a zerocoupon bond and a regular bond is that a zerocoupon bond does not pay couponsÂ or interest paymentsÂ to the bondholder, while a typical bond does make these interest payments.
The holder of a zerocoupon 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
Zerocoupon bondholders gain on the difference between what they pay for the bond and the amount they will receive at maturity. Zerocoupon bonds are purchased at a large discount, known as deep discount, to the face value of the bond.
A couponpaying bond will initially trade near the price of its face value. In other words, a zerocoupon 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 oneyear zerocoupon bond with a face value of $1,000, which can be purchased for $952.38 or a oneyear 5% semiannual coupon bond trading at its face value of $1,000. If you bought the zerocoupon 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 ZeroCoupon Bond
As noted above, an investor makes money on a zerocoupon bond by being paid interest upon maturity.
The amount of time involved for a zerocoupon bond to reach maturity depends on whether the bond is a shortterm or longterm investment. A zerocoupon bond that is a longterm investment generally has a maturity date that starts around 10 to 15 years.
Zerocoupon bonds that are considered shortterm investments typically have a maturity that is no more than one year. Such shortterm bonds are usually called bills. Because zerocoupon bonds return no interest payments throughout the maturation processÂ â€“ for example, 17 yearsÂ â€“ 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 zerocoupon bonds. However, a family saving to buy a vacation retirement home could benefit significantly from a zerocoupon bond with a 15 or 20year maturity. A zerocoupon 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.
Zerocoupon bonds issued in the U.S. retain an original issue discount, or OID, for tax reasons. Zerocoupon bonds often input receipt of interest payment, or phantom income, despite the fact the bonds do not pay periodic interest.
For this reason, zerocoupon bonds subjected to taxation in the U.S. can be held in a taxdeferred retirement account, allowing investors to avoid paying tax on future income. As an alternative to this process, if a zerocoupon 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.

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