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Bond Basics: Zero-Coupon Bonds

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Bonds help add diversity to your portfolio and control risk. But they can be complicated. We can help you understand the basics and make bonds work for you.

See Also: The Basics of Investing in Bonds

With a conventional bond you can typically expect to receive an interest payment every six months. Zero-coupon bonds, on the other hand, credit you with regular interest but don't actually pay any until maturity.

You buy the bond at a substantial discount from its face value, then collect the full value years later. Zeros usually come in denominations as low as $1,000 and are sold at discounts from face value of 50% to 75%, depending on the maturity. You can buy a zero-coupon bond to pay for college bills ten years down the road, sock it away, and forget about it until you withdraw the money. You're paying tomorrow's bills today, at a big discount.

There's one big gotcha, though. Even though you receive no annual interest, the IRS requires that you report the phantom payments just as if you were getting the checks. You owe tax each year on the prorated difference between what you paid for the bond and what you'll receive when it matures.

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This makes zeros attractive chiefly to people with IRAs, on which they needn't pay tax until they take the money out. Zeros are available as municipal bonds, which also spare you the annual reporting chore. Most are Treasury issues, which escape state income taxes. Zeros are also an attractive way to give financial gifts to kids, who will probably be taxed at a lower rate than you would be.

Zeros carry the usual market risks for investors, with this added kicker: The company that issues a zero could conceivably default without ever having paid you a penny of interest.

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