Some bonds pay no interest while the loan is maturing. These bonds, called
zero coupon bonds,
are popular with some investors. Instead of separate fixed-interest payments, the interest of a zero coupon bond accrues, or builds up, and is paid in a
lump sum
at maturity. Corporate, municipal, and Treasury bonds are all available as zero coupon bonds.
You buy zero coupon bonds — called zeros — at a
deep discount,
far lower than par value. When the zero matures, the accrued interest and the original investment add up to the bond's par value.
The pros and cons
Bond issuers like zeros because there's an extended period to use the money they have raised without paying periodic interest. Investors like zeros because the discounted price means you can buy more bonds with the money you have to invest, and you can buy bonds of different maturities, timed to coincide with anticipated expenses.
Zeros have two potential drawbacks. They are extremely volatile in the
secondary market,
so you risk losing money if you need to sell before maturity. And, unless you buy tax-exempt municipal zeros, or buy zeros in a tax-free account, you have to pay taxes every year on the interest you would have received had the interest, in fact, been paid.
Alexandra Lebenthal, President and Chief
Executive Officer of
Alexandra &
James, Inc.
If you're in your 20s and 30s and want to diversify your portfolio, zero coupon bonds can be great investments. The smaller amounts that are required for buying zero coupons let you get into the bond market more easily. And if you're investing for your child's education, zero coupons can be a real plus, in part because they offer tailor-made maturities.
Alexandra Lebenthal, President and Chief