Zero-coupon bonds are bonds that bear no interest for the duration of the bond’s existence. Rather than that, investors purchase zero-coupon bonds at a substantial discount to their face value or the amount the investor will receive when the bond “matures” or matures.
Zero-coupon bonds typically have long maturity dates—many do not mature for ten, fifteen, or more years. These long-term maturity dates enable an investor to prepare for a long-term objective, such as financing a child’s college tuition. With the deep discount, an investor can invest a small sum that will grow over time.
Investors can acquire many types of zero-coupon bonds issued by a range of issuers, including the US Treasury, businesses, and state and local government bodies, in the secondary markets.
Because zero-coupon bonds pay no interest until maturity, their secondary market prices fluctuate more than other types of bonds. Additionally, even though zero-coupon bonds do not pay interest until they mature, investors may be subject to federal, state, and local income taxes on the imputed or “phantom” interest that accrues each year. Certain investors avoid paying tax on imputed interest by acquiring municipal zero-coupon bonds (assuming they reside in the state where the bond was issued) or the rare tax-exempt corporate zero-coupon bonds.