What in the world
is a zero-coupon bond?
Hearing the finer points of bonds explained leaves
you feeling like you're listening to a foreign language. No matter
how many times you get it pounded into your head that a bond's yield
moves in the opposite direction of its price, you still find your
eyes glazing over and your head starting to nod.
So the concept of the zero-coupon bond is going to
be a real snooze, right? Well, I can't promise to turn bond investing
into John Woo directing Jackie Chan, but I can give you a pretty
clear idea of what you're getting into when you step up to the plate
with one of these securities.
First, some definitions might be useful. A bond is
essentially an IOU sold by governments and companies to investors
that guarantees that borrowers will repay borrowed money to the
lenders, at certain interest rates by a certain time.
A coupon is the interest an investor receives on bonds
he or she owns -- a check arrives every six months until the bond's
principle is due. Back in the dark ages, bonds actually used to
come with small, detachable coupons that bondholders would physically
redeem to receive the interest they were owed. Today, bond interest
is usually paid through electronic transfer, but the anachronistic
Two other useful definitions are face value, which
is the value of the bond at the time it's redeemed, and maturity
date, which is the date at which you are able to redeem your bond
for cash at face value.
For example, if a bond with a $1,000 face value matures
on Dec. 31, 2000, you will receive $1,000 on that date. It doesn't
matter if interest rates are up or if the Dow and Nasdaq are in
the toilet. Unless the borrower defaults, the investor will receive
the face value of her bond on its maturity date.
A zero-coupon bond is a bond that is bought at a deep
discount from its face value. It pays zero annual interest during
its life, but pays full face value on its maturity date. If you
buy a $10,000 zero-coupon bond for $5,000, you are buying it at
a deep discount. The discount -- in this case $5,000 -- is actually
the interest that will accumulate during the life of the bond. Most
people buy zeros issued by the U.S. Government or state and local
Some investors favor the zero because it provides
the comfort of a secure investment. If you buy a non-callable zero
-- one that the issuer cannot make you redeem before its maturity
date -- you effectively have a sure thing if you hold the bond to
If you need $10,000 in three years for school tuition,
or $30,000 in seven years to pay off a mortgage, the non-callable
zero will get you there. But to achieve this comfort level, you
need to be sure you're not going to have to cash it in before its
maturity date, because that would mean selling it on the open market
in competition with newer bonds that may be cheaper.
If interest rates have climbed since you bought it,
then the interest offered on a new bond will be more than $5,000,
which drops the purchase price of your bond below the amount you
paid. If you sell your bond, you may lose money.
Tax wise, if you buy municipal zeros, you're spared
the federal tax that is levied on Treasuries for each year's imputed
Investors who buy Treasury zeros often get around
the tax disadvantage by putting them in tax-deferred retirement
accounts, like an IRA, or the kids' accounts, if the children are
in a low-to-no income tax bracket.
-- Posted: Dec. 6, 2000