How to Buy Zero Coupon Bonds & How They Work

Zero coupon bonds offer a distinct approach to fixed-income investing, differing significantly from traditional bonds that provide regular interest payments. This article guides investors in understanding and acquiring these financial instruments, covering their operational mechanics, purchase locations, buying process, and tax considerations. By exploring these aspects, investors can determine if zero coupon bonds align with their financial objectives.

How Zero Coupon Bonds Work

Zero coupon bonds, often called “zeros,” do not pay periodic interest to the bondholder. Instead, investors purchase these bonds at a discount from their face value, also known as par value. The return on investment is realized when the bond matures, at which point the issuer pays the investor the full face value. For example, an investor might pay $3,500 for a bond with a $10,000 face value and receive $10,000 at maturity. The difference between the discounted purchase price and the face value represents the interest earned over the bond’s life.

The profitability of a zero coupon bond is measured by its yield to maturity (YTM), which is the total return an investor expects to receive if the bond is held until its maturity date. YTM accounts for the bond’s current market price, its face value, and the time until maturity. Another concept for these bonds is duration, which quantifies a bond’s price sensitivity to changes in interest rates. Zero coupon bonds, especially those with longer maturities, tend to have higher durations, meaning their prices can fluctuate more significantly with interest rate movements compared to bonds that pay regular coupons. Investors often consider zero coupon bonds for specific future financial goals, such as funding college education or retirement expenses, due to their predictable lump-sum payout at maturity.

Where to Purchase Zero Coupon Bonds

Investors can acquire zero coupon bonds through various channels. A common venue is a brokerage firm, which provides access to a broad range of zero coupon bonds, including those issued by corporations, federal agencies, and municipalities. Brokerage accounts allow investors to trade both newly issued bonds and those available on the secondary market.

For those interested in U.S. Treasury securities, TreasuryDirect is a direct-purchase platform managed by the U.S. Department of the Treasury. This platform is a direct source for purchasing Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities), which are zero coupon bonds created from the principal and interest components of standard Treasury notes and bonds. Treasury STRIPS are backed by the full faith and credit of the U.S. government, making them a low-risk investment. While TreasuryDirect focuses solely on government-issued securities, brokerage firms can also facilitate the purchase of Treasury STRIPS in the secondary market.

Steps to Buying Zero Coupon Bonds

The process of purchasing zero coupon bonds begins after establishing an investment account, either with a brokerage firm or directly through TreasuryDirect. The initial step involves funding the account, which can be done via electronic transfers, checks, or wire transfers, with processing times varying from one to several business days depending on the method. Once funded, the investor can begin researching and selecting specific zero coupon bonds that align with their financial objectives.

This research often involves using bond screeners provided by brokerage platforms to filter bonds based on criteria such as maturity dates, credit ratings (for corporate and municipal bonds), and desired yield to maturity. For instance, an investor saving for college in 15 years might seek bonds maturing around that timeframe. After identifying suitable bonds, the investor places an order, specifying the face value desired and potentially a target yield or price. The order is then executed, and the transaction undergoes a settlement process, which takes one to three business days (T+1 to T+3) for bonds, meaning ownership and funds are exchanged after this period.

Tax Considerations for Zero Coupon Bonds

The tax treatment of zero coupon bonds features “phantom income” or Original Issue Discount (OID). Even though investors do not receive cash interest payments until maturity, the Internal Revenue Service (IRS) requires them to report and pay taxes annually on the accrued interest. This means the difference between the bond’s discounted purchase price and its face value is considered imputed interest and is taxed each year as ordinary income.

The tax implications vary depending on the type of zero coupon bond. For example, interest income from corporate zero coupon bonds and Treasury STRIPS is subject to federal income tax annually. However, Treasury STRIPS are exempt from state and local income taxes. Municipal zero coupon bonds often offer significant tax advantages, as their interest income is usually exempt from federal income tax and, in some cases, from state and local taxes if the bond is issued within the investor’s state of residence.

To mitigate the impact of phantom income taxation, many investors choose to hold taxable zero coupon bonds within tax-advantaged accounts, such as Individual Retirement Arrangements (IRAs) or 401(k)s. Selling a zero coupon bond before maturity can also result in capital gains or losses, which are taxed separately from the OID.