What Is a Zero Coupon Bond?

The old Series EE paper savings bonds were prototypical government zero coupon bonds, and a traditional gift given to American toddlers for later use. Sadly, the Treasury doesn't sell them in this form anymore. Photo: Wikimedia Commons.

If you want to profit from the stock market, buy growth stocks. If you want a steady income stream, without all the market's ups and downs, buy bonds. That's the party line for bond investors. But in the case of one kind of bond in particular -- a zero coupon bond -- it's not how things work at all.

Generally speaking, income investors like to buy bonds because of the interest they pay out in the form of semi-annual "coupons." As the name implies, however, the interest, or coupon paid on a "zero coupon bond" is zero. As in nil.

Zilch.

A big fat zero.

Or at least, that's what a zero coupon bond will pay you during the life of the bond. This particular flavor of bond eschews periodic interest payments in favor of saving up the interest as it accrues, compounding that interest over time, and then paying out interest and principal, all in one big lump sum, on the day the bond matures, its due date.

How does a zero coupon bond work?
  With an ordinary corporate bond with a face value of $100, you pay $100 to the company, and the company pays you, say, 3% interest every year for 10 years. (This is only an example. The actual time period may be shorter, or much longer than 10 years). Over the 10 years, and you will collect a total of $30 in interest, plus, at the end of the term, the company pays you back your initial $100 investment.

In contrast, with a zero coupon bond with a face value of $100, paying 3%, you buy the bond for $74.41.  You then wait 10 years, and at the end of those 10 years, the company pays you $100. That $100 equals the price of your initial investment, plus all the interest that has built up over the 10 years from bond issuance to maturity.

How do I buy it?
"Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities." That's the official answer from the U.S. Securities and Exchange Commission .

In practice, though, you'll probably just log onto your online trading account and buy a bond right there. TD Ameritrade (NYSE: AMTD), for example, has a tool that will permit you to name the year you want your bond to be paid off, to limit your search to only zero coupon bonds, and even to pick the quality of the bond (its likelihood to eventually pay you as promised, rather than default).

A quick search for bonds maturing in 2025 -- 10 years from now -- generates no fewer than 25 different bonds available for sale, paying anywhere from 2% to 3% interest, most from government issuers. For each bond of $1,000 face value, a price is quoted as a percentage of that face value. So for example, a $1,000 Federal Home Loan Mortgage Corporation zero coupon bond paying 2.78% interest at maturity has a price quoted at "76.872" -- and will cost you only $768.72 to buy.

Click on the bond type you want to buy, enter the multiple of $1,000 in face value that you want to buy, click "Buy," and you're done.

Should I buy it? 
If you have a set date in mind, and need to come up with a set amount of money on it -- say, your granddaughter will head off to college 10 years from now, and you want to help out with the tuition -- then buying a zero coupon bond could be a great way to ensure you'll have the right amount of cash available when you need it.

Buy $10,000 worth of zero coupon bonds today, paying 3% interest and maturing in 2025, and you'll pay $7,441. Assuming the bond issuer pays as promised, you'll get back $10,000 in 2025. No worries about whether the stock market goes up or down. No need to cash and reinvest periodic coupon payments to ensure your money keeps compounding. Just set it and forget it.

On the other hand, by deferring receipt of all interest on your zero coupon bond until maturity, you will be limited in your ability to react to rising interest rates. With an ordinary bond, as interest rates rise but you receive steady semiannual interest payments, you can use that interest cash to buy more bonds paying better interest. With a zero coupon bond, you get no cash back until the end.

That may not matter to you. The security of knowing you'll receive a fixed amount at a definite date in the future may make up for earning a bit less profit on your investment. Also, if interest rates fall rather than rise over course of your bond's maturation, you may be glad your interest rate is fixed. Either way, there are a lot of variables to consider with zero coupon bonds -- as with any investment.

To learn more about this unique way to play the bond market, and to learn more about bond investing in general, head on over to The Motley Fools' Bond Center for a longer, free tutorial on all things bonds-related.