Many investors like bonds because they offer a reliable income stream without the same risks associated with the stock market. Most bonds are purchased at or around their face value, and investors make money by collecting interest payments, typically twice a year. Then, when the bonds mature, or come due, investors get their principal back as well.
Zero-coupon bonds work differently. Also known as accrual bonds, zero-coupon bonds are debt securities that are sold at a deep discount for a price far below their face value. The reason? Unlike traditional bonds, zero-coupon bonds don't make regular interest payments. Rather, investors profit at maturity, when the bonds are redeemed at their full face value. While there are some benefits of investing in zero-coupon bonds, they're not the right choice for everyone.
How zero-coupon bonds work
When an entity issues bonds, it is essentially borrowing money from investors and agreeing to make interest payments in exchange. It's those interest payments that incentivize investors to buy bonds in the first place. Zero-coupon bonds, however, don't make interest payments. Rather, investors make money from zero-coupon bonds by buying them for less than their face value and collecting their principal and interest payments together at maturity. (In this case, the interest at maturity represents the difference between the purchase price of the bond and its actual face value.) So while a traditional bond with a $10,000 face value might sell for $10,000, a zero-coupon bond with a $10,000 face value might sell for $5,000 initially.
When to consider zero-coupon bonds
Zero-coupon bonds are a good choice if you're looking to save for a particular milestone in the future. If, for instance, you're hoping to pay for your kids' college in 10 years, you might buy some zero-coupon bonds knowing you're likely to get a certain amount of income from your investment at a fixed time down the line. Similarly, zero-coupon bonds can be a good choice for investors who want to save for retirement. While you won't benefit from interest payments along the way, if you time your investment right, you stand to collect a larger sum when the bond matures during your senior years.
Drawbacks of zero-coupon bonds
As is the case with all investments, there are a few negatives to consider as well. While zero-coupon bonds don't make regular interest payments, you might still be liable for taxes on what's known as the phantom interest that accrues each year. In other words, you might pay taxes each year on the prorated difference between what you paid for your bonds and the total you stand to receive once they mature.
There are, however, a couple of ways to avoid this. First, if you hold zero-coupon bonds in your IRA, you won't pay taxes until you begin taking withdrawals. Additionally, if you buy zero coupon municipal bonds, you'll avoid taxes at the federal level. And if the bonds you purchase are issued by your home state, you'll avoid state and local taxes as well.
If you are going to invest in zero-coupon bonds, make sure the issuer has a strong credit rating. If you buy zero-coupon bonds and the issuer defaults, you stand to lose out on that eventual interest, thus rendering your investment not worth your while.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!