Zero coupon bonds pay no interest, you buy at less than face value
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Zero Coupon bonds are purchased at a discount and they will fund the face value at maturity. A portion of the funds at maturity will be accumulated interest (the discount) and the original amount of the purchase price of the coupon. At maturity when a zero-coupon bond matures, the investor will receive one lump sum equal to the initial investment plus interest that has accrued.
Zero coupon bonds have a duration equal to the bond’s time to maturity, which makes them sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons from the principal of coupon bonds, which is known as the residue, so that different investors may receive the principal and each of the coupon payments. This creates a supply of new zero coupon bonds.
The maturity dates on zero coupon bonds can vary and usually, the time period for these bonds is a longer time period. Often these maturity periods may be 15, 20 years or more. Investors can purchase 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.
Zero coupon bonds pay no interest until maturity but these are not necessarily deferred payments. The tax liability may still need to be paid annually because of the assumed yield which is also known as the phantom tax. By using zero coupon bonds issued by municipalities the income tax can be avoided. Occasionally a for-profit corporation may issue a special tax-exempt zero coupon bond which will not have annual tax liability tied to it.
The primary benefit of zero coupon bonds to investors is that they can lock in current interest rates for the duration of the bond. Investors are attracted because they allow an investor to accumulate a fixed amount of money by a specified date, lock in the current interest rate until maturity, and there is no call option risk in most bonds.
U.S. government zero-coupon bonds and corporate zero-coupon bonds are currently taxable as ordinary income to the investor even though the investor receives no current interest income from the bonds.
Another use for zero coupon bonds is to use them as a basic investment in an IRA. Because they are placed in an IRA the tax liability is deferred until the funds in the IRA are accessed. Zero coupon bonds provide long term yields with a guaranteed locked-in interest rate.
The Security and Exchange Commission (SEC) has more information, here is the link: https://www.sec.gov/fast-answers/answerszerohtm.html
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