Zero Coupon Bonds

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus interest that has accrued.

The maturity dates on zero coupon bonds are usually long-term—many don’t mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the deep discount, an investor can put up a small amount of money that can grow over many years.

Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities.

Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. In addition, although zero coupon bonds do not pay any interest until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying the imputed tax by buying municipal zero coupon bonds (if they live in the state where the bond was issued) or purchasing the few corporate zero coupon bonds that have tax-exempt status.

The Bond Market Association has more information about zero coupon bonds, Putting Compound Interest to Work Through Zero Coupon Bonds and An Investor's Guide to Tax Exempt Zero Coupon Municipal Bonds.

http://www.sec.gov/answers/zero.htm