Zero-Coupon Security

Security that makes no periodic interest payments but instead is sold at a deep discount from its face value. The buyer of such a bond receives the rate of return by the gradual Appreciation of the security, which is redeemed at Face Value on a specified maturity date. For tax purposes, the Internal Revenue Service maintains that the holder of a zero-coupon bond owes income tax on the interest that has accrued each year, even though the bondholder does not actually receive the cash until maturity. The IRS calls this interest imputed interest. Because of this interpretation, many financial advisers recommend that zero-coupon securities be used in Individual Retirement Accounts or Keogh Accounts, where they remain tax-sheltered.

There are many kinds of zero-coupon securities. The most commonly known is the zero-coupon bond, which either may be issued at a deep discount by a corporation or government entity or may be created by a brokerage firm when it strips the coupons off a bond and sells the Corpus and the coupons separately. This technique is used frequently with Treasury bonds, and the zero-coupon issue is marketed under such names as CATS (Certificate of Accrual on Treasury Securities), Tiger (Treasury Investors Growth Receipt) or Strips (separate trading of registered interest and principal of securities). Zero-coupon bonds are also issued by municipalities. Buying a municipal zero frees its purchaser of the worry about paying taxes on imputed interest, since the interest is tax-exempt. Zero-coupon certificates of deposit and zero mortgages also exist; they work on the same principle as zero-coupon bonds-the CD holder or mortgage holder receives face value at maturity, and no payments until then. Zero-coupon securities based on Collateralized Mortgage Obligation bonds are called Z-tranche bonds. Some mutual funds buy exclusively zero-coupon securities, offering shareholders a diversified portfolio that will mature in a particular year.

Zero-coupon securities are frequently used to plan for a specific investment goal. For example, parents knowing their child will enter college in 10 years can buy a zero that will mature in 10 years, and thus be assured of having money available for tuition. People planning for retirement in 20 years can buy 20-year zeros, assuring them that they will get the money when they need it.

Because zero-coupon securities bear no interest, they are the most Volatile of all fixed-income securities. Since zero-coupon bondholders do not receive interest payments, zeros fall more dramatically than bonds paying out interest on a current basis when interest rates rise. However, when interest rates fall, zero-coupon securities rise more rapidly in value than full-coupon bonds, because the bonds have locked in a particular rate of reinvestment that becomes more attractive the further rates fall. The greater the number of years that a zero-coupon security has until maturity, the less an investor has to pay for it, and the more Leverage is at work for him. For instance, a bond maturing in 5 years may double, but one maturing in 25 years may increase in value 10 times, depending on the interest rate of the bond. See also Accrual Bonds; Coupon Bond; Deep Discount Bond; Split-Coupon Bonds; Stags; Stripped Bond; Zero-Coupon Convertible Security.

Debt security, sold at a deep discount from its face value, that pays no interest during its stated life. The holder, in effect, receives interest in one lump sum at maturity. Interest payments are represented by the accretion from the original sale price to redemption at par. This interest deferral is attractive to investors who are not taxed on current income, for example, those investing in tax-deferred savings plans, such as an Individual Retirement Account, Keogh accounts, and so on, or who expect that bond interest when paid will be offset by future expenses, for example, college tuition expenses.

Annual interest earned is treated by the IRS as taxable income, even though there is no cash payment of interest. Thus, the appeal of zero-coupon securities lies in the fact that these securities eliminate Reinvestment Risk or risk of market rates rising or falling, because the interest earned is determined in advance by the interest accruals. Zero-coupon bonds, however, are more volatile in yield than bonds paying coupon interest semiannually.

A number of zero-coupon securities have been issued in recent years. Examples are stripped securities, such as U.S. Treasury Strips (Separate Trading of Registered Interest and Principal of Securities), which actually are created by dealers who turn back large blocks of Treasury securities for stripping. The Treasury Department separates the bond Corpus from interest Coupons exchanging the whole-coupon securities for U.S. Treasury Strips. Synthetic zero-coupon securities are issued by dealers who separate the principal of Treasury bonds from semiannual interest payments and sell the two pieces separately. A trust receipt is issued to the holder of these discounted securities. Among synthetic strips issued are Certificates of Accrual on Treasury Securities (CATS), Treasury Income Growth Receipts, and ZEBRAs (Zero-coupon Eurosterling Bearer with Registered Accruing Securities) issued in the U.K. Treasury STRIPs are also transferable in Book Entry Security form, making them slightly more liquid than synthetic strips.

Other variations of the discount, single payment investment are the zero-coupon certificate of deposit, zero-coupon municipal bond, and the Zero-Coupon Mortgage. See also Zero-Coupon Convertible Bond.