1. 25 Investments: Introduction
  2. 25 Investments: American Depository Receipt (ADR)
  3. 25 Investments: Annuity
  4. 25 Investments: Art and Collectibles
  5. 25 Investments: Bonds
  6. 25 Investments: Cash
  7. 25 Investments: Closed-End Investment Fund
  8. 25 Investments: Common Stock
  9. 25 Investments: Convertible Bonds
  10. 25 Investments: Corporate Bond
  11. 25 Investments: Futures Contract
  12. 25 Investments: Life Insurance
  13. 25 Investments: The Money Market
  14. 25 Investments: Mortgage-Backed Securities
  15. 25 Investments: Municipal Bonds
  16. 25 Investments: Mutual Funds
  17. 25 Investments: Options (Stocks)
  18. 25 Investments: Exchange-Traded Funds
  19. 25 Investments: Preferred Stock
  20. 25 Investments: Private Equity
  21. 25 Investments: Real Estate & Property
  22. 25 Investments: Real Estate Investment Trusts (REITs)
  23. 25 Investments: U.S. Treasury Securities
  24. 25 Investments: Unit Investment Trusts (UITs)
  25. 25 Investments: Venture Capital
  26. 25 Investments: Zero-Coupon Securities
  27. 25 Investments: Conclusion

A zero-coupon security, or "stripped bond", is basically a regular coupon-paying bond without the coupons. The process of "stripping" or "zeroing" a bond is usually done by a brokerage or a bank. The bank or broker stripping the bonds then registers and trades these zeros as individual securities.

Once the bonds are stripped, there are two parts: the principal and the coupons. The interest payments are known as "coupons", and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are bundled and referred to as zero-coupon bonds or "zeros".

You can think of a zero-coupon security just like a T-bill. Basically, you pay a certain amount right now in exchange for the par value of the security at a future date, usually $1,000. For example, you might pay $800 for a zero-coupon bond today and in five years you will receive the par value of $1,000. The longer the time to maturity, the cheaper you can buy the bond for. This predictability also makes zeros popular - when you buy the security, the yield is essentially locked in.

 

Objectives and Risks

The basic objective of a zero-coupon security is "buy low, sell high". You purchase the bond for a sum of money, and once it reaches maturity you will be paid an even larger sum of money. When interest rates are low, the price of the zero will be higher. The best time to buy a zero is when interest rates are high because the bond will be at a deeper discount.

The one major problem with zeros is that the annual accumulated return is actually considered to be income, and while you don't actually collect that interest until the bond reaches maturity, you still have to pay income tax on it. In other words, the gains on a zero are not treated as capital gains, instead they are considered to be interest.

 

How To Buy or Sell It

Zero-coupon securities can be bought through most full service or discount brokers, commercial banks, and some other financial intermediaries.

Strengths

 
  • Zeros can be bought at huge discounts.
  • Once you buy a zero-coupon security, you essentially lock in the yield to maturity.

Weaknesses

 
  • If the company issuing the zero goes bankrupt or defaults, then you have everything to lose. Whereas, with a regular coupon bond, you may have at least gotten some interest payments out of the investment.
  • Interest earned on the zero-coupon bond is taxed as income (a higher rate) rather than capital gains.

Three Main Uses

 
  • Capital Appreciation
  • Tax-Deferred Savings
  • Predictability

 

 

 

 


25 Investments: Conclusion
Related Articles
  1. Investing

    All About Zero Coupon Bonds

    Zero-coupon bonds are bonds that do not make any interest payments (which investment professionals often refer to as the "coupon") until maturity. For investors, this means that if you make an ...
  2. Investing

    How Are Zero-Coupon Municipal Bonds Taxed?

    What every investor needs to know about taxes and zero-coupon muni bonds.
  3. Investing

    Zero-Coupon Bond

    A zero-coupon bond or ‘no coupon’ bond is one that does not disburse regular interest payments. Instead, the investor buys the bond at a steep discount price; that is, at a price ...
  4. Investing

    Introduction To STRIPS

    STRIPS provide an alternative form of bond for fixed-income investors who need definite cash flows at specific times. Read the article to find out how.
  5. Investing

    Explaining Original Issue Discount

    An original issue discount is the amount below par at which a bond or other debt instrument is issued.
  6. Investing

    Corporate Bonds: Advantages and Disadvantages

    Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
  7. Investing

    Comparing Yield To Maturity And The Coupon Rate

    Investors base investing decisions and strategies on yield to maturity more so than coupon rates.
  8. Investing

    How Does A Bond’s Coupon Interest Rate Affect Its Price?

    All bonds come with a coupon interest rate, which is the fixed annual interest a bond pays.
  9. Investing

    Explaining the Coupon Rate

    Coupon rate is the stated interest rate on a fixed income security.
Frequently Asked Questions
  1. Why Do Most of My Mortgage Payments Start Out as Interest?

    Fear not: Over the life of the mortgage, the portions of interest to principal will change.
  2. What is the difference between secured and unsecured debts?

    The differences between secured and unsecured debt, and how banks buffer risks associated with each type of loan through ...
  3. How Many Times has Warren Buffett Been Married?

    Warren Buffett has been married twice in his life, but the circumstances surrounding the marriages were unconventional.
  4. What's the smallest number of shares of stock that I can buy?

    Many people would say the smallest number of shares an investor can purchase is one, but the real answer is not as straightforward. ...
Trading Center