How do zero coupon bonds work

After they're issued, zero-coupon bonds trade on the secondary market like other debt securities. Since zero-coupon bonds do not provide regular interest payments, their issuers must find a way to make them more attractive to investors. As a result, these bonds often come with higher yields than traditional bonds. The amount varies, but a US Treasury zero often yields at least one percentage point more than its traditional Treasury counterpart, and sometimes a lot more.

In , for example, a year Treasury zero was yielding as much as an annualized 3. The current yield on a year Treasury bond is 1. It may sound small, but thanks to the miracle of compounding, it adds up — especially over time. The other big advantage of zero-coupon bonds is their predictability. If these bonds are held to maturity, you're guaranteed a return of the full face value.

Plus, you'll have gotten a deal: paying less now for more later. For this reason, these bonds are a good fit for investors who have a specific financial goal in mind, and a long-term but specific time-frame. Some bondholders don't want to wait until maturity to get their payout.

But if you want to sell your zero early, know that its price is very subject to interest rate fluctuations. Bond prices have an inverse relationship to interest rates, which means that their market value — their price — falls as interest rates rise.

That's true of bonds in general, but zeros are especially sensitive: Since they do not make interest payments, the size of the payoff that you get from the bond depends entirely on its present value at the time that it is sold. As a result, zero-coupon bond prices are more volatile — subject to greater swings when interest rates change.

Even though you're not actually getting any interest payments, and won't realize the profit on your zero until the bond pays out at maturity, the IRS acts as if you are. It calls this "phantom income" and it wants a piece. So, you likely have to pay taxes on the interest that "accrues" on the bond each year — not just federal, but state and local too. Are you prepared for your financial future? Use this checklist to get started. Please enter some keywords to search.

Breadcrumb Home Introduction to Investing Glossary. Each coupon, or interest payment, entitles its owner to a specified cash return on a specific date; the body of the security calls for repayment of the principal amount at maturity.

The body of the stripped securities and the separate coupons are known as "zero coupons" or "zeros" because there are no periodic interest payments on each instrument.

After stripping, the body and coupons are sold at a discount from their face values. An owner benefits only from the difference between the purchase price and the payment received upon sale or at maturity.

The result would be 41 separate zero-coupon instruments, each with its own maturity date. Each of the 41 securities, now possessing a distinct ID number, could be traded separately until its maturity date at prices determined by the market. Stripped securities offered investors a financial instrument that had abundant supply, no default risk, and low incidence of being "called," or paid off, before their maturity date. However, their popularity raised fears within the Treasury Department that zeros would result in a sizable loss of tax revenues.

A zero-coupon bond does not pay interest but instead trades at a deep discount, giving the investor a profit at maturity when they redeem the bond for its full face value. An investor chooses the zero-coupon bond they would like to purchase based on several criteria, but one of the main ones will be the imputed interest rate that they can earn at maturity. The price of a zero-coupon bond can be calculated with the following equation:. Imputed interest, sometimes referred to as "phantom interest," is an estimated interest rate.

The imputed interest on the bond is subject to income tax. The IRS uses an accretive method when calculating the imputed interest on Treasury bonds and has applicable federal rates that set a minimum interest rate in relation to imputed interest and original issue discount rules. Securities and Exchange Commission.

Corporate Bonds. Fixed Income Essentials. Treasury Bonds. Municipal Bonds. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.

We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses.