What is a Zero-Coupon Certificate Of Deposit (CD)
A zero-coupon certificate of deposit is a certificate of deposit 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 a yearly 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.
BREAKING DOWN Zero-Coupon Certificate Of Deposit (CD)
A zero-coupon certificate of deposit is a CD sold at a steep discount, which then pays out the face value at maturity. Its name comes from the fact that it has no “coupon” or annual interest payment. This investment product is considered a low-risk. The low-risk assessment is due, in part, to it being bank issued, which is regarded as more stable than private companies and are also backed by the Federal Deposit Insurance Corporation.
Pros and Cons of Zero-Coupon Certificates of Deposit
There are positives and negatives of 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 to investors is the way the treatment of interest from a tax perspective. Interest income paid annually is 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 entice the purchase, the buyer must be aware of yearly tax obligations.
- Sold mainly through a brokerage firm, the buyer will likely also incur broker fees.
- Some zero-coupon CDs are callable, meaning they can be called back by the issuing bank and reissued at a current lower interest rate.
- These CDs also provide no steady, ongoing income since the holder must wait until the time of maturity for the payout.