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.
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” a