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.
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.
How Do I Calculate Yield To Maturity Of A Zero Coupon Bond?
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.