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
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.
What is the difference between a coupon bond and a zero-coupon bond? ›
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 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.
Why do people want zero coupon bonds? ›
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 is the difference between a strip bond and a zero-coupon bond? ›
A strip bond is a debt instrument in which both the principal and regular coupon payments—which have been removed—are sold separately. A strip bond is also known as a zero-coupon bond.
How risky are zero-coupon bonds? ›
Zero-coupon U.S. Treasury bonds have a poor risk-return profile when held alone. Long-dated zero-coupon Treasury bonds are more volatile than the stock market, but they offer the lower long-run returns of U.S. Treasuries. Even worse, there is no guarantee that they will go up when stocks do poorly.
What are the advantages & disadvantages of a zero-coupon bond? ›
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 bond and a coupon? ›
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 zero-coupon bond and a Treasury bill? ›
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.
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.
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 you pay taxes on zero coupon bonds? ›
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. 1 It can be challenging to come up with the money to pay taxes on income that was not received.
Is there capital gains on zero coupon bonds? ›
Notified zero coupon bonds issued by REC and NABARD are taxable. Gains from zero coupon bonds are subject to capital gains tax on maturity. The capital appreciation for zero coupon bonds is the difference between the maturity price and purchase price of the bond.
What is the main difference between a coupon bond and a zero-coupon bond? ›
A zero-coupon bond does not pay interest to bondholders, in contrast to a conventional bond that does. Instead, holders of zero-coupon bonds simply get the bond's face value when it matures. Regular bonds, also known as coupon bonds, pay interest throughout the bond's life and then return the principal at maturity.
How do you know if a bond is zero-coupon? ›
The zero-coupon bond definition is a financial instrument that does not pay interest or payments at regular frequencies (e.g. 5% of face value yearly until maturity). Rather, zero-coupon bonds offer a one-time payment at maturity in the form of one face value.
Why do people buy strip bonds? ›
Benefits of strips
Known yield: with a set maturity date and a purchase price at a discount, you have a fixed yield. Low maintenance: no need to worry about reinvesting small amounts of interest every six months, possibly at a lower rate ("coupon reinvestment risk" is a feature of conventional bonds)
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.
Is a zero-coupon bond a debt or equity? ›
A zero-coupon bond is a debt security instrument that does not pay interest. Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity.
Is a zero-coupon bond a junk bond? ›
Zero-coupon bonds emphasize the discount element of income to the exclusion of coupons; junk bonds emphasize the risk element contained in the interest yield on such securities; and indexed bonds simply match the rate of return, through either coupons or discounts, to some specified index in the hope of accurately ...
