Loading the player...

What is a 'Zero-Coupon Bond'

A zero-coupon bond, also known as an "accrual bond," is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

Some zero-coupon bonds are issued as such, while others are bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price much more than coupon bonds.

BREAKING DOWN 'Zero-Coupon Bond'

When a zero coupon bond matures, the investor receives one lump sum equal to the initial investment plus the imputed interest.

The maturity dates on zero coupon bonds are usually long term, with many having initial maturities of at least 10 years. These long-term maturity dates can allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the bond's deep discount, an investor can put up a small amount of money that can grow over many years.

Investors can choose zero coupon bonds that are issued from a variety of sources, including the U.S. Treasury, state/local government entities, and corporations.

Example

Most bonds provide semiannual interest payments, while zero coupon bonds do not pay cash coupons. Rather, the investor receives one payment at maturity which is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. Zero coupon bonds credit investors with regular interest although the cash coupon is not paid until maturity.

Zero coupon bonds are sold at a substantial discount from the face amount. For example, a bond with a face amount of $20,000 maturing in 20 years with a 5.5% yield may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,757 represents the interest that compounds automatically until the bond matures,

Other Factors

Prices fluctuate more than with other types of bonds in the secondary market because zero coupon bonds pay no interest until maturity. In addition, although no coupon payments are made on zero coupon bonds until maturity, investors may still have to pay federal, state and local income taxes on the imputed or phantom interest that accrues each year. Purchasing a municipal zero coupon bond, buying zero coupon bonds in a tax-exempt account, or purchasing a corporate zero coupon bond that have tax-exempt status may be one way to avoid paying income taxes.

RELATED TERMS
  1. Coupon Rate

    The yield paid by a fixed income security. A fixed income security's ...
  2. Coupon Bond

    A debt obligation with coupons attached that represent semiannual ...
  3. Current Coupon Bond

    A bond with a coupon rate that is within 0.5\% of the current ...
  4. Coupon Stripping

    The separation of a bond's periodic interest payments from its ...
  5. Ex Coupon

    A bond or preferred stock that does not include the interest ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
Related Articles
  1. Investing

    Explaining the Coupon Rate

    Coupon rate is the stated interest rate on a fixed income security.
  2. Investing

    What is a "Coupon"?

    In the financial world, “coupon” represents the interest rate on a bond.
  3. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  4. Investing

    An Introduction to Individual Bonds

    Individual bonds are better than bond funds and can be a key component to one’s investment strategy.
  5. Investing

    If I Buy A $1,000 10-Year Bond With A 10% Coupon, Will I Receive $100 Each Year?

    Investors can count on a fixed-income security paying them a certain amount of cash as long as the security is held until maturity and the issuer doesn’t default.
RELATED FAQS
  1. How do debit spreads impact the trading of options?

    Find out what it means when a bond has a coupon rate of zero and how a bond's coupon rate and par value affect its selling ... Read Answer >>
  2. How do I calculate yield to maturity of a zero coupon bond?

    Find out how to calculate the yield to maturity for a zero coupon bond, and see why this calculation is more simple than ... Read Answer >>
  3. Why do zero coupon bonds tend to be volatile?

    Learn why the price of zero coupon bonds is volatile and why some investors may wish to hold them in retirement accounts ... Read Answer >>
  4. What is the difference between yield to maturity and the coupon rate?

    A bond's coupon rate is the actual amount of interest income earned on the bond each year based on its face value. The yield ... Read Answer >>
  5. What is the most common solvency ratios used in fundamental analysis?

    Learn about the difference between a bond's coupon rate and its yield rate, how the coupon rate influences market price and ... Read Answer >>
  6. If I buy a $1,000 bond with a coupon of 10% and a maturity in 10 years, will I receive ...

    Simply put: yes, you will. The beauty of a fixed-income security is that the investor can expect to receive a certain amount ... Read Answer >>
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
  3. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  4. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  5. Absolute Advantage

    The ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost ...
  6. Nonce

    Nonce is a number added to a hashed block, that, when rehashed, meets the difficulty level restrictions.
Trading Center