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Zero Coupon Bonds

Bonds that are bought at a deep discount and pay no rate of interest are known as zero coupon bonds. These securities will mature at a larger face value than the price it was bought at.

These investments offer growth within a bond, but they do not offer any current income. These can be found in funds and annuities, since many of those assets are long term.

Taxation

The holder of a ZERO-COUPON BOND (non-interest-bearing) buys the bond at a discount because the discount is treated as interest that the bondholder will receive at the bondís maturity. Bondholders must accrete (amortize up) the amount of the discount each year and claim the accreted amount as portfolio income and add it to their taxable income. In essence, investors pay tax on money they do not see, but on the other hand, they do not have to pay a capital gain or ordinary income at maturity

All bonds bought at a discount that mature have a capital gain. Instead, all of the gain is ordinary income. The premium can be amortized each year to offset the interest paid. An investor cannot deduct a capital loss if the premium bond is held to maturity and the investor has not amortized the premium over the time the bond has been held. If a discount bond is sold prior to maturity, the bond is accreted, a new cost basis is found, and the sale price is subtracted from the new cost basis to determine if there is a gain, loss, or if the appreciation is ordinary income.

Tax is normally paid each year on the earned interest from zero coupon bonds. This is also known as phantom income, so there is no taxation advantage to them unless they are bought into an IRA or other tax deferred account.

Investment Risks

Fiixed income investments and bonds that do not have a coupons or nominal yields have little or no reinvestment risk. The term reinvestment risk refers to an investor having to deposit or invest their interest payments received from other securities. When interest rates are low, this risk can be amplified. However with 0 coupon bonds - that issue is minimized by the fact that no payments are received until maturity. Since Zeros are usually longer term - this risk is even less realized.

Treasury STRIPS are also Zero coupons. T Strips are Government guaranteed bonds that have no interest paid until the end. Also municipalities and corporations offer them. Municipal bonds use zero coupons to lower their interest cost while financing state, city and local projects.

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