Zero Coupon Bonds

Zero-coupon bonds (zeros) are bonds in which there is no stated coupon rate, and so there is no current interest paid on them. Zeros are also sold at a discount, which is usually quite substantial. Their return to the investor is measured by their yield to maturity. For example, you wish to purchase a zero with a face value of $10,000 and a maturity date of 2018. You buy it for $2000. Because it is a zero-coupon bond, you will receive no interest payments. How- ever, when the bond matures in 2018, you will receive the $10,000. However, if you were to sell the bond before it matures, you would realize a gain (or loss) if the sale price is more (or less) than your adjusted tax basis in the bond.

Any type of bond can be a zero-coupon bond. They don’t just have to be municipals or corporate bonds. The primary benefit of zeros to investors is that they can lock in current interest rates for the duration of the bond. Investors are attracted to zeros because they allow an investor to accumulate a fixed amount of money by a specified date, lock in the current interest rate until maturity, and there is no call risk in most circumstances. But if you need current income before the bonds mature, you should consider purchasing bonds that pay current interest. Zeros may also be used for the long-term end of a bond portfolio since there is generally no call risk.

U.S. government zero-coupon bonds and corporate zero-coupon bonds (issued after July 1, 1982) are currently taxable as ordinary income to the investor even though the investor receives no current interest income from the bonds. The amount that is taxable is the annual amount of accrued original-issue discount. This is calculated by applying the bond’s yield to maturity to an adjusted issue price. Because taxable zeros cause the investor to pay taxes, they are generally held in tax-qualified plans such as IRAs and qualified retirement plans. Holding zeros in these types of plans is beneficial to the investor because no tax is due on these until distributions begin. Municipal zero-coupon bonds are, like other muni bonds, taxexempt. For these bonds, accrued original-issue discount is not included in the investor’s gross income; it is tax-exempt. Therefore, municipal zeros are more frequently held in direct ownership by investors.