In layman's terms, zero coupon means "no interest." Zero coupon bonds do not pay interest during the life of the bond. Instead, they accrue interest all along and reinvest it at the same interest rate. When you invest in a bond, the entity issuing it (usually a government or business) pays you the principal and interest when the bond matures. You buy zero coupon bonds at a deep discount, much less than the face value at maturity. Though they don't come without risk, they are considered to be more conservative investments than something like stocks, if you keep them until they mature.
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Purchase zero coupon bonds as a less-volatile alternative to playing the stock market. While not risk free, bonds are still a more predictable investment than many other investments. You will get a lump sum payment at maturity if you are able to hold on to your bonds for the long term.
View zero coupon bonds as a long-term investment. You can reduce your risk with these bonds by holding on to them until maturity. Use them for long-term savings goals such as buying a new house or paying for a child's education.
Defer paying federal taxes on your bond income by purchasing the bonds through your tax-deferred retirement account. Interest on zero coupon bonds is taxable for the current income year, although the interest is reinvested and you do not receive it in the same year. If you purchase bonds through a retirement account, you are not taxed on the proceeds until you retire.
Avoid paying federal taxes on zero coupon bond earnings by buying tax-free municipal zero coupon bonds. These are issued through states, counties, and other local agencies and the interest is usually exempt from federal taxes.
Understand that the more you pay for the bond, the less your yield will be. For example, if a bond is worth $1,000 at maturity (its face value) and you buy it for $700, you know you will be earning $300 in interest on it at maturity. If you buy it for $600, you will make $400 in interest at maturity.
Visit your full-service or discount broker to purchase zero coupon bonds. All brokers pay the same amount of money for zero coupon bonds, but their markups or commissions will differ. The face value of the bond is the same no matter where you buy it.
Tips and warnings
- Avoid losing money by purchasing insurance with zero coupon bonds so that if the issuer defaults on the bonds, you don't lose everything.
- Selling zero coupon bonds before maturity is a job for professionals. If interest rates increase and you sell your zero coupon bond before maturity, you could actually sell it for less money than what you paid. Also, issuers are allowed to "call" the bond if the interest rates drop and pay you the interest, then reissue the bond at the lower interest rate.