What Is a Zero-Coupon Bond?

Bonds are a favorite among income investors because of their low risk and the predictable cash flow they generate. But there’s a unique class of bonds that don’t provide passive income. They’re called zero-coupon bonds, and they can add diversity and balance to portfolios while helping investors save for long-term goals.

See: 3 Things You Must Do When Your Savings Reach $50,000

They’re not for everyone and they come with both benefits and drawbacks, but they can provide a relatively safe and potentially lucrative alternative for some bond investors.

Here’s what you need to know about zero-coupon bonds.

What Is a Zero-Coupon Bond?

A zero-coupon bond is a type of bond that does not pay periodic interest — or coupon payments — like traditional bonds. Instead, they are issued at a steep discount and provide a return to the investor by paying out the difference between the purchase price and the bond’s par, or face value, at maturity.

Here’s how it works.

Investors purchase zero-coupon bonds below face value, which is the amount the bond will be worth when its term expires. When the bond comes due, the investor collects its face value and pockets the difference.

For example, if you buy a zero-coupon bond with a face value of $10,000 and a 10-year maturity at a discount price of $6,500, you’ll get back your $6,500 principal plus $3,500 in profit when the 10-year term is up.

Since zero-coupon bonds do not pay interest and generate their returns through their reduced purchase price, they are sometimes referred to as discount bonds or simply zeros.

Why Would You Buy a Zero-Coupon Bond?

Investors purchase zero-coupon bonds because they guard their principal and deliver predictable returns over long periods of time — their terms are usually a decade or more.

Some investors include discount bonds in their portfolios to add a different kind of exposure to already-diverse bond holdings. Others use them in pursuit of long-term financial goals like saving for college. Since they provide known and fixed returns for set periods, investors can expect their capital to be intact when they need it on a specific target date in the future.

Are Zero-Coupon Bonds a Good Investment?

Since the primary allure of bonds is the periodic interest payments their investors collect as passive income, purchasing bonds that don’t pay interest might feel counterintuitive. But zeros earn their place in portfolios through their reliability and the hefty lump sums they pay investors in the future.

The difference between the bond’s discounted purchase price and its face value represents the periodic interest payments that investors don’t receive during the bond’s term.

For example, if a zero-coupon bond with a $20,000 face value and a 20-year term pays 5.5% interest, the interest rate is knocked off the purchase price and the bond might sell for $7,000. In two decades, the investor collects a lump sum of $20,000, earning $13,000 as the sum of all the compounded interest in one payment.

What Are the Pros and Cons of Zero-Coupon Bonds?

Like all investments, zero-coupon bonds have benefits and drawbacks that investors must consider before putting their money into play. Here’s a look at the pros and cons of discount bond investing.

Pros

• Higher yields: Since zeros don’t generate cash flow, their issuers must make them attractive to investors by offering higher interest rates than traditional bonds. According to Business Insider, U.S. Treasury zeros typically yield at least one percentage point more than their traditional Treasury counterparts. Investors pay less now for the promise of more later.

• Predictability over time: If you retain a discount bond through its period of full maturity, you’re guaranteed to receive its full face value.

• High liquidity: Many investors don’t want to wait for the full term that the bond requires to mature. Since zeros are highly liquid, it’s easy to sell them on the open market at any time.

• Investors can capitalize on interest rate fluctuations: Since bond yields have an inverse relationship with interest rates, their values rise when interest rates fall, so investors might be able to sell their zeros early at a profit in low-interest environments.

Cons

• No interest payments: Because of the lump sum payment framework, zeros don’t provide passive income in the form of periodic interest payments like traditional bonds.

• Long terms: Since their terms are typically 10 years or more, zero-coupon bond investors often have to wait decades to receive their principal payment and their return.

• They’re susceptible to interest rate fluctuations: Zeros are more vulnerable to interest rate volatility than traditional bonds. Since they lose value when rates rise, you can lose money if you sell a zero before its maturity date in an unfavorable interest environment.

• They carry inflationary risks: Because of their long terms, inflation can reduce the value of discount bonds. In the previous example, the investor paid $7,000 for a bond that guaranteed a $13,000 return 20 years later — but thanks to inflation, the purchasing power of $13,000 can decline dramatically over two decades.

• Phantom income: Although discount bond investors don’t receive periodic payments, the IRS requires them to recognize so-called “phantom income” — imputed interest from the lump sum they expect to collect in the future. This can increase their tax liability. Municipal zeros generate tax-free imputed income, which means you don’t have to pay taxes on them until they mature. On the other hand, corporate discount bonds typically result in an annual tax liability.

Something To Consider

Separate Trading of Registered Interest and Principal Securities, or STRIPS, are among the most popular kinds of zero-coupon bonds. The U.S. Treasury doesn’t sell STRIPS directly, but third-party dealers, brokers or financial institutions can convert Treasury securities into STRIP bonds by stripping them of their interest.

This article originally appeared on GOBankingRates.com: What Is a Zero-Coupon Bond?