Most people think of bonds as being appropriate for those who need regular current income without a huge amount of risk. Yet some bonds are structured specifically not to pay income currently. The special ways in which these zero coupon bonds work can make them appropriate for very different uses than the typical fixed-income security.
What is a zero coupon bond?
With most bonds, the issuer accepts an up-front payment from investors in exchange for promising to pay interest payments at regular intervals and then repay the principal at maturity. For instance, a 10-year Treasury bond might have a coupon rate of 3%, meaning that each $1,000 face-value bond will make interest payments totaling $30. For Treasuries, that would come in two semiannual payments of $15 each, but the frequency with which issuers pay interest can vary from bond to bond. Typically, newly issued bonds are priced in a manner that's consistent with prevailing market conditions at the time they're issued, so investors could expect to pay about $1,000 if they purchase the Treasury bond above at auction.
Zero coupon bonds work a bit differently. As the name suggests, the issuer has no obligation to make any interest payments during the term of the bond. Only at maturity must the issuer repay the face value of the bond.
As you can imagine, investors aren't willing to pay the same amount for a zero coupon bond that they would for a bond that pays interest. Zero coupon bonds are therefore sold at a discount to their face value. So for instance, a 10-year zero coupon bond priced when prevailing yields were 3% would typically get auctioned for roughly $750 per $1,000 in face value. The $250 difference would essentially represent the interest over that time frame, but the bondholder wouldn't actually receive cash until the maturity 10 years from now.
Why are zero coupon bonds useful?
There are two very different reasons why various investors like zero coupon bonds. For one group, the absolute certainty of receiving a fixed amount on a fixed date in the future is extremely valuable. For example, if you're running a pension fund and you know for certain that you'll need $10,000 in 2028, it's helpful to be able to spend $7,500 right now and be assured that it will grow to the needed amount over the next 10 years.
Another group of investors likes zero coupon bonds because of their sensitivity to rate changes. Because all of the return of a zero coupon bond gets incorporated into its price, changes in rates have a more dramatic impact on zero coupon bond prices than with their interest-paying counterparts. The longer the maturity, the greater the price sensitivity. Therefore, if you want to bet on interest rates moving a particular direction, zero coupon bonds are your best way to maximize profit from any given rate move.
The downsides of zero coupon bonds
For some investors, being more sensitive to rate changes is a negative rather than a positive. If you don't intend to hold your bond to maturity, you have to stay aware of market fluctuations, and extreme volatility for zero coupon bonds can work against you if rates don't move the way you want. Specifically, if rates rise, they make the value of your zero coupon bond go down, potentially forcing you to sell at a depressed price if your timing is bad.
Another problem with zero coupon bonds is that IRS laws typically force you to recognize taxable income every year. Despite the fact that you don't actually receive an interest payment in cash, the IRS requires you to impute the amount of interest you should have gotten, based on the initial yield. So, for instance, if you spent $750 on a 10-year $1,000 zero coupon bond, then the fact that the bond was priced to yield around 3% would mean that you'd have to pay tax on 3% of its value each year, which would slowly rise from $22.50 to $30 per year as the bond approached maturity. Fortunately, you might be able to avoid this issue by holding zero coupon bonds in a tax-favored account like an IRA.
Take a look at zero coupon bonds
Despite their dangers, zero coupon bonds let you do some unusual things. Rate speculation can be risky, but the rewards can be impressive if you make the right bet. Meanwhile, if you have specific cash needs at a given time that you don't want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals.