CHAPTER 14 ADVICE FROM AN EXPERT: Zero-Coupon Bonds …



CHAPTER 14 ADVICE FROM AN EXPERT: Zero-Coupon Bonds Pay Phantom Interest

Zero-coupon bonds (also called zeros or deep discount bonds) are municipal, corporate, and Treasury bonds that pay no annual interest. They are sold to investors at sharp discounts from their face value and may be redeemed at full value upon maturity. For example, a 7 percent, $1000 zero-coupon bond to be redeemed n the year 2025 might sell today for $258. Zeros pay no current income to investors, so investors do not have to worry about reinvesting any interest payments. The interest, which is usually compounded semiannually, accumulates within the bond itself, and the return to the investor comes from redeeming the bond at its stated face value at the maturity date. In this manner, zeros operate much like Series EE savings bonds and T-bills. The maturity date for a zero could range from a few months to as long as 30 years.

Parents often invest in zero-coupon bonds to help pay for their children’s college education, and they wisely establish ownership of the zeros in the child’s name. The phantom income “paid” to the child is generally so small that little, if any, income taxes are due.

Treasury zeros, unlike most other zeros, are not callable. People planning for retirement buy zeros because they know exactly how much will be received at maturity. Because zeros pay “phantom interest,” the investor owes income taxes every year on the interest that accumulates within the bond, even though the investor receives no interest money until maturity. Many investors avoid income taxes altogether by buying zeros with funds in a qualified tax-sheltered retirement plan account.

Liz Dolan, Associate Professor

University of New Hampshire

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