Zero coupon investments offered by the U.S. Treasury are all taxable. They include certificates of accrual on Treasury securities, or CATS; Treasury investment growth receipts, or TIGRs; and Treasury-issued separate trading of registered interest and principal of securities bonds, or STRIPS. While you don't get any payments from the bonds before you exchange them on their maturity date, the Internal Revenue Service generally requires you to pay tax on the gradual increase in value while you own them.
A zero coupon bond is one that only makes a single payment at maturity. It's called a zero coupon since it doesn't have any of the interest, or coupon, payments that a traditional bond would offer. Since all that you get is a single payment at some point in the future, a zero coupon bond sells at a discount to the value of that future payment. The difference between the discount at which you buy the bond and the value at maturity is what gives you your return.
In the 1970s, investors started splitting Treasury securities into their constituent pieces in a process called stripping. For instance, a 30-year bond could be stripped into 61 different pieces -- 60 different semiannual interest payments and a 61st payment of the bond's face value. The government shut down the tax advantages of stripping bonds into zeroes in 1982. Even without the tax advantages, though, investors still wanted zero coupon bonds, and investment banks responded by buying bonds and selling stripped securities that were backed by pools of bonds. Those securities included the TIGRs, CATs and U.S. Treasury-issued STRIPS.
When you own zero coupon investments like CATS or TIGRs, you do get a return because those bonds theoretically grow in value as they get closer to their maturity date. However, you don't get a check from them like you would with a regular bond that has its coupons. The "phantom" interest that you earn is taxable like any other interest you might earn from a similar non-zero coupon bond. Because CATS and similar investments create tax liability without throwing off money to pay the taxes, some investors choose to hold them in tax-deferred accounts such as individual retirement accounts.
Zero coupon bonds like CATS tend to be interest-rate sensitive. This means their prices can bounce around in the positive and negative. If you sell a CATS investment on the secondary market for a profit, you will have to pay capital gains tax on your trading profit. The profit is calculated relative to the imputed interest you already paid tax on while you owned the bond.
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