The difference between a regular bond and a zero-coupon bond is the payment of interest, otherwise known as coupons. A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments. Instead, zero-coupon bondholders merely receive the face value of the bond when it reaches maturity. Regular bonds, which are also called coupon bonds, pay interest over the life of the bond and also repay the principal at maturity.
Key Takeaways
- A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments.
- A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve.
- Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated short-term price movements.
- Zero-coupon bonds can help investors to avoid gift taxes, but they also create phantom income tax issues.
The Difference for Investors
Long-term zero-coupon bond investors gain the difference between the price they pay for the bond and the amount they receive at the bond's maturity. This amount can be substantial because zero-coupon bonds are typically purchased at deep discounts to the bond’s face value. This discount frequently leads to higher returns in the long-run.
A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. With a normal yield curve, long-term bonds have higher yields than short-term bonds. The interest payments made by regular coupon bonds are due before the date of maturity, so those payments are like small zero-coupon bonds that mature earlier. Interest payments cut down the wait time and the risk, so they also reduce expected returns.
The absence of coupons does not make zero-coupon bonds bad investments, and they usually offer better returns than coupon bonds.
The Difference for Speculators
Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated short-term price movements. All other things being equal, the price of a zero-coupon bond will increase more than the price of a regular coupon bond when interest rates fall. Because U.S. Treasury bond prices respond strongly to interest rate changes, zero-coupon Treasuries are preferred for speculating on interest rates.
Zero-coupon corporate bond prices are also volatile, so they can be used for speculating on the health of the issuing company. Suppose that a company facing bankruptcy previously issued zero-coupon and coupon bonds that both mature in five years. The market price of both bonds would have plummeted, with the result that the coupon bonds now pay very high interest relative to their purchase price. That creates a cushion if the company should go bankrupt before maturity. The zero-coupon bond has no such cushion, faces higher risk, and makes more money if the issuer survives.
Zero-Coupon Bonds and Taxes
Zero-coupon bonds may also appeal to investors looking to pass on wealth to their heirs. If a bond selling for $2,000 is received as a gift, it only uses $2,000 of the yearly gift tax exclusion. However, the recipient ultimately receives substantially more than $2,000 after the bond reaches maturity. Unfortunately for zero-coupon bondholders, some taxes can reduce the effectiveness of this strategy.
In the U.S., zero-coupon bonds create a tax liability for interest payments, even though they don’t actually pay periodic interest. That creates a phantom income problem for the bondholders. It can be challenging to come up with the money to pay taxes on income that was not received. Consequently, it is often a good idea to hold zero-coupon bonds in a tax-deferred retirement account to avoid paying tax on future income.
A zero-coupon bond issued by a U.S. local or state government entity is another alternative. All interest on these municipal bonds, including imputed interest for zero-coupon bonds, is free from U.S. federal taxes. Municipal bonds are often free from state and local taxes as well.
FAQs
Zeros, as they are sometimes called, are bonds that pay no coupon or interest payment. With a conventional bond, you can typically expect to receive a coupon payment every six months. Zero-coupon bonds, on the other hand, credit you with interest but don't actually pay any until maturity.
What is the difference between a zero-coupon bond and a coupon bond? ›
The difference between a regular bond and a zero-coupon bond is the payment of interest, otherwise known as coupons. A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments.
Why would anyone buy a zero-coupon bond? ›
After 20 years, the issuer of the bond pays you $10,000. For this reason, zero coupon bonds are often purchased to meet a future expense such as college costs or an anticipated expenditure in retirement. Federal agencies, municipalities, financial institutions and corporations issue zero coupon bonds.
What are the pros and cons of zero-coupon bonds? ›
Zero-coupon bonds offer unique investment opportunities for various investor profiles, with their predictable returns, lower initial investments, and lack of reinvestment risk. However, these bonds also present certain challenges, such as interest rate risk, credit risk, and tax implications.
What is the difference between a zero-coupon bond and a coupon bond quizlet? ›
The difference between a coupon bond and a zero coupon bond is that the zero coupon bond pays all of its coupons at maturity.
Do you pay taxes on zero coupon bonds? ›
Zero-coupon Treasuries are taxed as if you were receiving annual interest income, even though you won't receive any income until the bond matures.
Does a zero-coupon bond pay interest? ›
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond "matures" or comes due.
What is the biggest risk of zero coupon bonds? ›
One of the biggest risks of zero coupon bonds is their sensitivity to swings in interest rates. In a rising interest rate environment, their value is likely to fall more than other bonds.
How do you make money on a zero-coupon bond? ›
These bonds are issued at a deep discount and repay the par value, at maturity. The difference between the purchase price and the par value represents the investor's return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.
Do zero coupon bonds always sell at a discount? ›
Therefore, a zero-coupon bond must trade at a discount because the issuer must offer a return to the investor for purchasing the bond.
Zero-coupon bonds guarantee payments for the bondholders once the bond reaches maturity. Investing in zero-coupon bonds may be more cost-effective and attractive for investors with specific financial goals in mind, who can invest over a long time.
Are Treasury bills the same as zero-coupon bonds? ›
Treasury bills are also known as zero coupon bonds, meaning unlike bonds and notes, they don't pay a fixed interest rate. Instead, Treasury bills are sold at a discount rate to their face value.
What is zero-coupon bond also known as? ›
A zero-coupon bond (also discount bond or deep discount bond) is a bond in which the face value is repaid at the time of maturity. Unlike regular bonds, it does not make periodic interest payments or have so-called coupons, hence the term zero-coupon bond.
What is the difference between a bond and a coupon bond? ›
A bond's yield to maturity rises or falls depending on its market value and how many payments remain. The coupon rate is the annual interest amount that the bond owner will receive.
What is the difference between a strip bond and a zero-coupon bond? ›
STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. These types of bonds are generally known as zero-coupon bonds since they pay no interest or coupon.
What is the difference between zero-coupon bond and junk bond? ›
Zero coupon bonds are bond that pays no annual interest but sells at a deep discount to its par value while Junk bonds are those bonds which have little protection against default. Junk bonds are also known as high yield bonds and these are viewed as highly speculative securities.
What is the difference between a deferred coupon bond and a zero-coupon bond? ›
Deferred coupon bonds, sometimes called split coupon bonds, pay no coupons for their first few years but later pay higher coupons. Such bonds are common in project financing. Zero-coupon bonds are an extreme form of deferred coupon bonds that pay no interest and, thus, are issued at a deep discount.
