Bonds are part of the family of investments known as fixed-income securities. These securities are debt obligations, meaning one party is borrowing money from another party who expects to be paid back the principal (the initial amount borrowed) plus interest.
How an Investor Makes Money From a Coupon-Paying Bond
Investors (the holders of the bond) can make money on bonds in two ways.
First, as we already mentioned, the holder receives interest payments – known as the coupon – throughout the life of a bond. For instance, if you bought a 10-year bond with a coupon rate of 8%, the issuer would send you a coupon (interest) payment of $80 every year. Most bonds pay twice a year, and so, technically, you would receive two checks for $40 each.
Second, bonds fluctuate in price similar to any other security. This price fluctuation depends on a number of factors, the most important of which is the interest rate in the market. Some investors attempt to make money from the changing price of a bond by guessing where interest rates will go.
How an Investor Makes Money From a Zero-Coupon Bond
An investor makes money on a zero-coupon bond by being paid interest upon maturity. Also known as a discount bond, a zero-coupon bond is a type of bond purchased for an amount lower than its face value, which means that the full face value of the bond is repaid when the bond reaches maturity.
The party who issues the bond does not make interest payments (coupon), but pays the full value once the maturation process is complete. U.S. Treasury bills (T-bills) and savings bonds are two examples of zero-coupon bonds. Though most zero-coupon bonds pay a set amount of money (giving them a set face value), some bonds are inflation-indexed, in which case the amount paid back to the bondholder is determined to have a specified amount of purchasing power instead of a specific dollar amount.
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. These short-term bonds are usually called bills.
Because zero-coupon bonds return no interest payments throughout the maturation process, if there is a case where a bond does not reach maturity for 17 years, investors in the bond do not see any profit for nearly two decades. A retired investor, for example, seeking to maintain a steady flow of income would likely see 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 (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.
(For further reading, see the Bond Basics Tutorial).