Unlike regular coupon bonds, most of which pay interest semi-annually, zero coupon bonds make no interest payments while the bond is outstanding. Instead, the interest accrues (builds up) and is paid all at once at maturity. Because zeros are offered at a deep discount to face value, they are subject to greater volatility than coupon bonds. As market conditions change, the market value of zero coupon bonds fluctuates more than regular coupon bonds and, therefore, may not be suitable for all investors.
- Zeros are issued by major corporations, municipalities, and the U.S. Government.
- U.S. Government zeroes are similar to U.S. Treasury bills in that they are sold at a discount to the face value of the bond. Their value increases over time, until they eventually reach par value on the maturity date.
- The return is derived solely from the price increase between the time of purchase and the maturity date (or the sale date, if sold prior to maturity).
- Zero coupon bonds make no interest payments while the bonds are outstanding; instead, the interest accrues and is paid all at once at maturity.
Zeros may be a good alternative if you have a specific time frame, such as a child's college tuition payments, and if you intend to hold the bonds until maturity. However, because of their volatility, they may not be suitable if you need immediate access to cash. Unless you hold them in a tax-deferred account, the interest that accrues on these bonds may be subject to income taxes annually, even though you don't receive any interest payments until maturity. (This generally does not hold true for interest payments on municipal zero coupon bonds, which generate tax-free income that is payable at maturity. Income for some investors may be subject to the federal alternative minimum tax.) You should consult your tax advisor about the special tax consequences of zero coupon bonds.