Zero-Coupon Bonds

Zero-coupon bonds, also called accrual bonds, pay no interest to investors. Instead, they are traded at a deep discount and render profit at maturity, whereupon the investor will receive one lump sum equal to the initial investment and all the value that has accrued. This is called "full face value." Zero-coupon bonds may be issued as such, or other bonds can be stripped down into component parts, one of which may be a zero-coupon.

Even though zero-coupon bonds do not distribute interest or principal payments during their lifetimes, bondholders may still have to pay federal, state and local taxes on the undistributed earnings these bonds accrue. One way around this is to invest in municipal zero-coupon bonds, which are tax free, or in one of the few corporate zero-coupon bonds that have tax-exempt status.

Because they do not pay interest during their lifetimes, the price of zero-coupon bonds is much more volatile in the bondmarkets and has far less attachment to interest rates than regular bonds.

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