Zero Coupon Bonds
A zero coupon bond (or “zero”) is one that makes no periodic interest payments. Instead, zero coupon bonds are issued at a deep discount to their face value, with the face (or par) value being delivered at maturity; a zero thus is a type of discount bond. Zero coupon bonds may be issued for as little as 10% to 15% of their face value, depending on prevailing interest rates and the term of the bond.
Zeros are usually issued in $5,000 increments. For example, a 20-year bond that has a par value of $5,000 may have a $1,000 issue price. A lower price means a greater return.
Zeros are attractive to the issuer (borrower), because they do not cost anything in terms of interest payments until the bond matures. They are attractive to the lender (investor), because they offer greater leverage. Instead of loaning $5,000 for $5,000 worth of bonds, in our example above, the investor needs to offer up only $1,000, freeing the balance for other investments. However, even though zeros do not make interest payments, the IRS treats the discount as interest, and the bondholder will need to pay taxes on this “phantom interest” at his ordinary income rate. In our example above, the taxpayer would have to calculate the discount and divide by the number of years to find the annual interest payment (($5,000 – $1,000) / 20 years = $200 per year).
Another advantage for the bondholder is that zero coupon bonds lock in the current interest rate for the life of the bond, eliminating reinvestment risk. If the investor had bought an interest-paying bond, the periodic coupon payments would need to be reinvested, possibly at lower interest rates than the coupon rate. With zeros, the coupon is effectively paid at maturity, meaning that it is always earning the prevailing interes