Bonds are often used to balance portfolio risk and access steady income. Corporations or municipal entities may issue bonds, which are typically thought of as less risky but also less potentially rewarding than stock investments. Bond returns are generally known in advance and paid out to the investors from the time of purchase until the bond reaches maturity.
The interest rate (also referred to as the coupon payment) is disclosed before the sale. A zero-coupon bond does not issue interest payments. Instead, the bond is sold at less than the face value, and the gain for the investor is the difference between what they pay for the bond and what they receive back at maturity. With zero-coupon bonds, this may be a significant difference. These bonds are long-term investments and may attract investors seeking funding for a specific future expense.
The US Treasury, a prolific issuer of bonds, does not issue zero-coupon bonds, although some other municipalities do. However, financial institutions, brokers, and dealers can transform Treasury bonds into zero-coupon bonds by separating the principal and interest from the originally issued instrument. Each piece of the newly configured bond becomes an individual security that matures individually and has a set payment. STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities, and these bonds must be issued in increments of $100.
Most zero-coupon bonds are subject to capital gains taxes. However, since the interest isn’t paid during the bond’s life, the IRS assesses taxes against imputed interest. For example, suppose you buy a zero-coupon bond with a face value of $10,000 and a ten-year maturity. The formula to determine the price you pay is:
P=M/(1+r)n
With a 4% interest rate, the price for the bond would be $6,729.71, or 67.29 percent of the face value. The bond issuer doesn't pay interest, but the IRS imputes the earned interest annually. In this example, the interest would range from $108.75 in the first year to $379.26 in the final year. The bond investor must pay taxes on interest income they did not receive.
Imputed interest is sometimes called phantom interest and is used with other investments where the earnings are rolled over into retained earnings or reinvested. Investors may also pay state and local taxes on imputed interest unless they buy a tax-exempt zero.
However, since you have paid income tax on the imputed interest during the bond’s life, you are not subject to a capital gains assessment when the bond matures. If you sell the zero-coupon bond before maturity, you will likely owe capital gains taxes if you sell it for more than you paid.
All bonds have interest rate and inflation risks, including zero-coupon bonds. If interest rates rise after you buy it, the value of your bond on the secondary market will be less. Also, some bonds are callable, which means the issuer can require early redemption if rates rise. STRIPS are not callable, which reduces the interest rate risk.
When inflation rises, the bond's interest rate may not be adequate to keep pace with inflation, reducing the purchasing power of the bond’s returns. Zero-coupon bonds enjoy price gains when interest rates and inflation drop but may suffer value losses when rates or inflation rise.