What Is a Zero-Coupon Certificate of Deposit (CD)?
A zero-coupon certificate of deposit is a CD bought at a discounted rate. It differs from a traditional CD in that interest payments are paid out as a lump sum at the date of maturity, as opposed to being disbursed on an annual basis.
Zero-coupon CDs are a minimum-risk tool for investing and saving. They are generally a good fit for conservative, risk-averse investors for whom generating cash flow or ongoing income is not a priority.
- A zero-coupon CD is sold at a deep discount but still pays out the full price at maturity.
- This type of CD accrues interest but only pays it in one lump-sum at maturity.
- The holder of a zero-coupon CD must pay tax on the accrued interest annually, even though it has not yet been paid out.
Understanding a Zero-Coupon CD
A zero-coupon CD is a CD sold at a steep discount, which nevertheless pays out the full face value at maturity. Its name comes from the fact that it has no “coupon” or annual interest payment. This investment product is considered low risk—you invest your money and, provided you don't withdraw it early, your return is guaranteed over a certain time period. Although zero-coupon CDs are usually sold through brokerages, they can also be issued by banks, which means they are backed by the Federal Deposit Insurance Corporation (FDIC) as long as the bank is FDIC insured.
A downside of zero-coupon CDs is that they are sometimes callable, which means the issuer can redeem them before their maturity date.
Zero-Coupon CDs: Advantages and Disadvantages
There are positives and negatives to investing in zero-coupon CDs that buyers should keep in mind.
- You can generally buy these at a significantly discounted rate compared to the face value.
- Yield may be slightly higher than with a traditional CD.
- As with other types of CDs, these are low-risk investment tools.
- There is no reinvestment risk, unlike with an instrument that pays interest at regular intervals.
- They are insured by the FDIC up to $250,000, so investors have protections even if the issuing bank closes or fails to pay its investors for any reason.
- The main disadvantage of zero-coupon CDs is the treatment of interest from a tax perspective. Annual interest income is considered taxable income. The taxable status means it will affect the holder’s tax liability throughout the term of the CD, with tax payable every year on the accrued interest. Even though the price of the CD is discounted to far below par to make the purchase enticing, the buyer must be aware of yearly tax obligations.
- Zero-coupon CDs are sold mainly through brokerage firms, so the buyer will likely incur broker fees.
- Some zero-coupon CDs are callable, meaning they can be called back by the issuing bank prior to maturity and then reissued at a current lower interest rate.
- Zero-coupon CDs provide no steady, ongoing income, as the holder must wait until the time of maturity for the payout.