Bonds are among a number of investments known as fixed-income securities. They are debt obligations, meaning that the investor loans a sum of money (the principal) to a company or a government for a set period of time, and in return receives a series of interest payments (the yield). When the bond reaches its maturity, the principal is returned to the investor.
Making Money From a Coupon-Paying Bond
There are two ways that investors make money from bonds.
- The individual investor buys bonds directly, with the aim of holding them until they mature in order to profit from the interest they earn. They may also buy into a bond mutual fund or a bond exchange-traded fund (ETF).
- Professional bond traders dominate a secondary market for bonds, where existing issues are bought and sold at a discount to their face value. The amount of the discount depends partially on how many payments are still due before the bond reaches maturity. But its price also is a bet on the direction of interest rates. If a trader thinks interest rates on new bond issues will be lower, the existing bonds may be worth a little more.
In either case, the owner of the bond receives interest payments, known as the coupon, throughout the life of a bond, at the interest rate that was determined when it was issued.
- A coupon-paying bond pays a pre-determined amount of interest, usually twice a year until the date the bond matures.
- A zero-coupon bond is bought at a discount from its face value, and the investor receives the full face value when it matures.
- The interest paid on a bond may be pre-set or may be based on prevailing interest rates at the time it matures.
For instance, if you invested $1,000 in a 10-year bond with a coupon rate of 4%, the issuer would send you a coupon (interest) payment of $40 every year. Most bonds pay twice a year, so you would receive two checks for $20 each.
Making Money From a Zero-Coupon Bond
Investors in zero-coupon bonds receive no payments for their money until the bond matures. They buy the bond for an amount that is less than its face value. When it reaches its maturity, they are paid the full face value of the bond.
The zero-coupon bond also is known as a discount bond. U.S. Treasury bills (T-bills) and U.S. savings bonds are two examples.
In the secondary bond market, bonds are bought and sold at a discount to their face value based on the number of payments outstanding, plus the trader's bet on the direction of interest rates.
Most zero-coupon bonds have a pre-set face value and therefore pay a pre-set amount of money at maturity. Some bonds are inflation-indexed, meaning the face value is determined at maturity. The amount paid will be based on a standard measure such as the consumer price index plus a premium.
Types of Zero-Coupon Bonds
Bonds are issued with maturity dates that vary in their length of time.
Zero-coupon bonds that are considered short-term investments typically have a maturity of no more than one year. These short-term bonds are usually called bills.
A zero-coupon bond that is a long-term investment may have a maturity date of 10 to 15 years or more.
Coupon-Paying Bond Vs. Zero-Coupon Bond
Coupon-paying bonds are a frequent choice of older investors and retirees who value the steady income that the payments provide and the relative safety of bonds as an investment.
Those short-term Treasury bills have the same benefits as reliable income supplements and safe investments.
The long-term zero-coupon bond holds little attraction for most older investors and retirees, who are unlikely to want to tie up their money for decades.
Such a long-term bond might, however, be useful as part of a young family's savings plan. It also can be used by wealthy investors as a vehicle for passing on an inheritance.
Tax Benefits of Zero-Coupon Bonds
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 subject to taxation in the U.S. can be held in a tax-deferred retirement account, allowing their investors to avoid tax on future income.
If a zero-coupon bond is issued by a U.S. local or state government entity, interest is free from federal tax and generally exempt from state and local tax as well.