investing

Bond Basics: Zero-Coupon Bonds

These investments are attractive only to a select few. Find out if they're right for you.

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.

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.

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.

Most Popular

Why Are Gas Prices Still Going Up?
spending

Why Are Gas Prices Still Going Up?

The cost of a gallon of gas is at an all-time high. What’s driving the surge and will gas prices go down anytime soon?
May 23, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Which States' Taxes Are Going Down
Tax Breaks

Which States' Taxes Are Going Down

State lawmakers are cutting income, sales and property taxes to return budget surpluses to residents.
May 25, 2022

Recommended

Is the Stock Market Closed on Memorial Day 2022?
Markets

Is the Stock Market Closed on Memorial Day 2022?

The stock market gets a full day off for Memorial Day. The bond market gets Monday off too, not to mention an early close ahead of the holiday weekend…
May 27, 2022
What Is Preferred Stock, And Should I Buy It?
investing

What Is Preferred Stock, And Should I Buy It?

Thinking of adding preferred stock to your portfolio? Read on for a breakdown of the pros and cons to buying preferred shares.
May 26, 2022
Sometimes Renting Is Better Than Buying
investing

Sometimes Renting Is Better Than Buying

A home is an asset that generally appreciates in value, but it might not be the most optimal way to build wealth from an investment point of view.
May 25, 2022
Bond Values in a Volatile Market
Investing for Income

Bond Values in a Volatile Market

While the market's instability may not be over just yet, the latter half of the year should be less daunting – and possibly more rewarding – for inves…
May 25, 2022