Zero Coupon Bonds: Not Great for Most People

There are essentially an infinite amount of investments out there. If you have a specific investment appetite or desire, you can find the vehicle you need. One of those vehicles that is not thought of very often are zero coupon bonds. Here’s how they work.

What is a Zero Coupon Bond?

A zero coupon bond is a bond that does not have regular coupon payments. But instead pays out a premium when it has fully matured.

Bonds are simply a loan that you (the investor) give to a government entity or to a corporation. Think of yourself as the bank and a government entity or corporation who is coming to you for a loan. It’s really as simple as that. 

With a bond, you (the investor) loan money and that money is returned to you in the form of interest payments (called coupons) for a specified period of time. At the end of that time, your original loan amount (investment) is returned.

But with a zero coupon bond, there are no interest payments. You simply get the full price of the bond back at a later date.

Let’s look at an example of a 10-year, $1,000,  zero coupon bond purchased at $900.

This is basically how they work. It’s not really fancy. 

Zero coupon bonds (like other bonds) can be issued by the federal government, state governments, municipalities, or corporations.

Who Can Benefit from a Zero Coupon Bond?

Zero coupon bonds are usually used for very specific purposes. Usually the person who purchases them needs the money back at a later date but does not need the regular coupon payments that would come with a normal bond.

It is unusual for someone to purchase one of these, but there are very specific circumstances where someone might want one.

How are They Treated for Tax Purposes?

This is the worst part about zero coupon bonds (IMO). You still have to pay taxes on them even though you haven’t made any money on them until it matures.

So for the example above, each year you would have to pay taxes on $10. The $10 represents the amount that the bond has “earned” in that year. (Even though you didn’t get any of that money.)

This is called phantom income. And the IRS likes to make sure that they get their chunk of flesh so they tax you on it even though you didn’t actually earn that money or see that money that year.

Yuck.

Final Thoughts

Zero coupon bonds are not for everyone. In fact, I would argue that they are only for a few people in a few situations. 

If you are just trying to find out where to invest your money, look elsewhere. 

Go to your 401k or an IRA first. 🙂

You can do this!

Until next time!