When investors purchase bonds, they act as lenders to the entity that issues the bonds. They typically obtain returns annually or semiannually as coupon payments. However, when investors purchase zero-coupon bonds, they do not receive coupon payments. Instead, they purchase the bonds at deep discounts and then receive the amount of the bond when it has fully matured. For instance, an investor may purchase a $20,000 zero-coupon bond that matures in 20 years for less than half that amount, but they cannot collect any money until the bond is fully mature. In the meantime, they have to pay federal, state, and local income tax on the imputed interest, or the interest that compounds annually.
Zero-coupon bonds offer advantages for long-term investors, who appreciate the certainty that they will collect a specific amount of money when the bond is fully mature. If investors are looking for options to be able to reach long-term goals such as funding for the education of their children or for their retirements, they can purchase zero-coupon bonds, knowing the exact amount of funds that will be available to them in the future.
Zero-coupon bonds are ideal for those who want to make an investment and then not have to follow market trends on an ongoing basis. Basically, investors can "invest and forget" until the bonds mature. The bonds carry minimal risk and are only subject to the capital gains tax. Because zero-coupon bonds are so deeply discounted, they require a low minimum initial investment.
It is also important to mention some of the drawbacks of zero-coupon bonds. For instance, investors receive no regular income from them, but they still have to pay taxes on the imputed interest. Additionally, because these bonds take so long to mature, inflation can sometimes eat up a large portion of the investor's profit.