Investeens

Definition: A bond that does not pay periodic interest to the bondholder over its term as an ordinary bond does. Instead, it is sold for less than its face value to investors who then wait until the maturity date, on which they'll receive the face value. The difference between what investors originally paid and eventually receive is the interest earned.

Example: In February, 2009, investors were able to purchase a new 30-year zero-coupon Treasury Strip bond that matures on February 15, 2039. The bond was offered to investors for a price of $247.40. Thirty years later, the investor will receive the $1,000 face value. Notice that unlike an ordinary bond, the investor receives no payments until the maturity date.

Investeens explains: While the above bond might seem like a great deal by paying $1.00 for about every $.25 invested, 30 years is a long period of time. To figure out how much is really being earned each year, we would have to find the rate at which we can grow $247.40 year-in and year-out for 30 years and have it reach $1,000.

While it is beyond the scope our discussion, by using the appropriate formula or a financial calculator, the rate of return this bond earns is 4.878%. If we take 4.878% of $247.40. We get $12.07. This is the interest the bond earns (but doesn't pay) in its first year. This makes the bond worth $247.40 + $12.07, or $259.47 at the end of its first year. To figure out how much the bond earns in its second year, we take 4.878% of $259.47. If we repeat this process for 30 years, the bond's value will grow to ... $1,000!

Above, we illustrated that zero-coupon bonds don't pay interest each year but they do earn interest each year. The Internal Revenue Service (IRS) takes a special interest in this. In fact, it says that holders of these bonds must pay income taxes on the interest they have earned. Too bad if they don't get it until the bond matures! For this reason, the interest is referred to as phantom interest, and zero-coupon bonds are not exactly investors' favorite. Another reason why this type of bond may not be up there on investors' wish list is that, because they don't pay the investor back a single dime until the very end, a failure of the issuing company or the government before maturity could leave investors scrambling to collect what they're owed!

There are ways to purchase zero-coupon bonds and not get bitten by taxes on phantom interest. One way is to purchase the bonds through a tax-deferred retirement account such as a 401-K or Individual Retirement Account (IRA). A second way to purchase zero-coupon bonds issued by state and local governments, called municipal bonds, which can be exempt from federal, state and local income taxes.

Finally, consider that zero coupon bonds, because they build up value over time, are better for saving than ordinary bonds. Imagine if you owned an ordinary $1,000 face value, 5% bond. It would pay you an interest check of 2.5% (or $25) every six months. You could easily spend that on dinner or a movie or an item of clothing. At the end of the bond's term, you'd get back the face value, wondering where all the interest went. Not so with a zero-coupon bond, because you can't spend what you don't get! On the flip side, realize that this type of bond would be awful for a retired person who needs to receive income (ie: interest checks) on a regular basis to live on.

Riddle me this:

1. How do zero-coupon bonds differ from ordinary bonds?
2. How do investors make money with these bonds?
3. What do we call interest that is considered earned but not received?
4. What is the IRS' position on this interest?
5. What is a reason why zero-coupon bonds are more risky than ordinary bonds.
6. Identify how investors can own zero-coupon bonds and not have to pay taxes on the annual interest earned.
7. Explain why these bonds are better for saving than ordinary bonds.
8. Explain which type of person these bond are not suited for, explaining why.

Also known as: Zeroes.

See related: 401-K, Bond, IRA, IRS, Municipal bonds, Rate of return.