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Zero-coupon CDs: What are they?

By Sheyna Steiner · Bankrate.com
Wednesday, July 21, 2010
Posted: 9 am ET

Most people have probably heard of a zero-coupon bond, or a bond that pays interest at maturity rather than accruing annually. But CDs also come in zero-coupon form.

Coupon refers to the interest rate on a bond.

According to the website, BondClass.com, zero-coupon CDs, or ZCDs, are issued in maturities between three and 30 years and can be callable.

Zero-coupon CDs are bought at a discount and when they mature are worth face value.

They can be confusing, says Herbert Hopwood, CFP and president of Hopwood Financial Services in Great Falls, Va.

For instance, "It's a 5 percent yield but zero coupon. You buy it at 95 cents on the dollar and in one year it's worth $1. It accretes the difference between 95 cents and $1 and that's the interest you've earned," he says.

One drawback to them is that the interest income you're not receiving every year is taxable. The interest accretes annually, though you don't get it until maturity, which means a bigger tax bill and nothing to show for it for a while.

Trivia question: Why is the interest rate on bonds called coupons?

Of course, it goes back to when people had physical stock or bond certificates.

I'm sure many young investors can go their entire lives now without getting a stock certificate. Though that's not necessarily a bad thing as far as organizational and record-keeping matters go, there is some charm in having an official embossed certificate on heavy paper. Now, the only people who will likely have them are scripophilists or collectors of historical stock and bond certificates.

According to Scripophilynews.com, old Lehman Brothers certificates sold recently for $300 each.

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