Zero coupon bonds, also known as zeros, are distinct in that they do not make annual interest payments. The bonds are sold at a deep discount, and the principal plus accrued interest is paid at the bond’s maturity date. The less you pay for a zero coupon bond, the higher the yield. A bond with a face value of $1,000 purchased for $600 will yield $400 at maturity. Zero coupon bonds are issued by the Treasury Department, corporations and municipalities. The bonds are considered a low-risk investment compared to stocks, commodities and derivatives.
Purchase Treasury zero coupon bonds if you want the best chance of having your principal and interest paid at maturity. Treasury zeros carry a lower interest rate than municipal zero coupon bonds and corporate zero coupon bonds, but they are backed by the full faith and credit of the United States. Many investors believe the safety inherent in the bonds makes up for the lower interest rate. The bonds are issued at a minimum face value of $1,000, and the earliest a Treasury zero bond matures is in 10 years. The bond interest income is taxed at the federal level and possibly at the state level.Step 2
Consider corporate zero coupon bonds if you are looking for high interest rates and can stomach the higher risk of default. Many corporate zeros have call provisions that allow the company to call in the bond issue before the maturity date. Corporate zeros are taxed at the owner’s tax bracket. The interest income after taxes might equal or be less than the interest paid on municipal zeros. Another point to consider is the company’s financial health. There’s no guarantee the company will be able to pay back the principal and accumulated interest at maturity.Step 3
Research municipal zero coupon bonds before you buy. Generally, municipalities with low credit ratings have to issue their bonds at a higher interest rate to attract buyers. Also consider how long you want to own the bond. Municipal zeros pay a higher interest rate the longer you hold them, and it can take as little as one year or as long as 40 years for the bond to mature. Municipal zeros have a lower interest rate than corporate zeros. But their income is exempt from federal and, in some cases, state and local taxes.Step 4
Contact your bank or broker with your zero coupon bond order. The bond selling price remains the same no matter who places your order, but keep in mind that a commission will be added to the bond purchase price. Use a discount broker instead of a full service broker to get a better rate on your commission fee.
- Use a rating service such as Moody’s, Standard & Poor’s or Fitch to find the credit rating for the entity issuing the bonds and for the bonds themselves.
- You must purchase zero coupon bonds through a bank, your broker, or a commercial dealer.
Based in St. Petersburg, Fla., Karen Rogers covers the financial markets for several online publications. She received a bachelor's degree in business administration from the University of South Florida.