Zero-Coupon Bond
Zero-Coupon Bond
A bond that makes no periodic interest payments (zero coupon) and is instead sold at a deep discount to its face value, with the full face value paid at maturity. The difference between the purchase price and maturity value represents the investor's return. Despite receiving no cash until maturity, investors must pay annual taxes on imputed interest (phantom income). Zero-coupon bonds have high interest rate sensitivity due to their long duration and are often used in tax-deferred accounts to avoid annual taxation.
An investor purchases a 20-year zero-coupon Treasury bond with a $10,000 face value for $3,118 (representing a 6% yield to maturity). Over 20 years, the investor receives no interest payments but must pay federal income tax annually on the imputed interest (the annual accretion toward $10,000). At maturity, the investor receives the full $10,000 face value, realizing a $6,882 gain. If interest rates rise to 7% after purchase, the bond's market value falls significantly due to its high duration, but the locked-in 6% return remains if held to maturity.
Students often don't understand that zero-coupon bond investors owe taxes annually despite receiving no cash (phantom income), underestimate the extreme interest rate sensitivity compared to coupon bonds, confuse the deep discount with a low coupon rate (there is NO coupon), or fail to recognize that zero-coupon bonds are best suited for tax-deferred accounts to avoid annual taxation on imputed interest.
How This Is Tested
- Identifying the tax implications of zero-coupon bonds, especially phantom income taxation in taxable accounts
- Comparing the interest rate sensitivity (duration) of zero-coupon bonds versus coupon-paying bonds
- Determining suitability of zero-coupon bonds for specific client goals (target date planning, college savings)
- Calculating the purchase price or yield to maturity for a zero-coupon bond given discount and maturity
- Understanding the absence of reinvestment risk with zero-coupon bonds versus coupon bonds
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Imputed interest taxation | Annual taxation required | IRS requires annual reporting and taxation of accrued interest (phantom income) even though no cash is received until maturity |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Jennifer, age 45, is planning for her daughter's college education in 15 years. She has $25,000 to invest and wants a guaranteed amount available when her daughter turns 18. Jennifer is in the 32% federal tax bracket and wants to minimize ongoing tax liabilities. Her investment adviser recommends zero-coupon Treasury bonds maturing in 15 years. Which of the following accounts would be most appropriate for this investment?
C is correct. A 529 college savings plan is ideal for zero-coupon bonds used for education funding because earnings grow tax-free and withdrawals for qualified education expenses are tax-free, eliminating the phantom income tax problem. The 15-year maturity matches the college timeline, and the tax-advantaged nature of the 529 avoids annual taxation on imputed interest.
A is inappropriate because in a taxable account, Jennifer would owe federal income tax annually on the imputed interest despite receiving no cash payments, creating a significant tax burden over 15 years at her 32% rate. B (traditional IRA) would defer the phantom income taxes, but using retirement funds for college is inefficient and may trigger penalties; plus, the IRA is designed for retirement, not education. D (Roth IRA) would eliminate taxes, but contribution limits ($7,000 annually as of 2024) would prevent Jennifer from investing the full $25,000, and using retirement funds for college undermines retirement planning.
The Series 65 exam frequently tests the suitability of zero-coupon bonds for specific goals and the critical importance of tax-deferred or tax-exempt accounts to avoid phantom income taxation. Understanding the annual tax burden on imputed interest is essential for appropriate client recommendations, especially for education planning and target-date objectives.
Which of the following statements best describes the primary characteristic that distinguishes zero-coupon bonds from traditional coupon-paying bonds?
B is correct. Zero-coupon bonds make NO periodic interest payments (hence "zero coupon") and are instead sold at a substantial discount to their face value. The investor's return is the difference between the discounted purchase price and the full face value received at maturity. This is the defining characteristic of zero-coupon bonds.
A is incorrect because zero-coupon bonds don't pay interest annually at all, not even at a 0% rate; there are simply no coupon payments of any kind. C is misleading because while the investor receives face value at maturity, zero-coupon bonds don't "accumulate" and pay interest as a lump sum; rather, the discount itself represents the interest, and the bond simply matures at par. D is false because zero-coupon bonds can be issued by corporations, municipalities, and the Treasury; they are not limited to Treasury securities and corporate zero-coupon bonds do carry default risk.
The Series 65 exam tests fundamental understanding of zero-coupon bond mechanics. Knowing that these bonds pay no periodic interest and derive their return entirely from the discount is essential for comparing them to coupon bonds, explaining them to clients, and understanding their unique tax and reinvestment risk characteristics.
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B is correct. For a zero-coupon bond, first-year imputed interest equals the purchase price multiplied by the yield to maturity: $6,139 × 5% = $306.95, approximately $307. This represents the amount by which the bond's book value increases in the first year (accretion), and the IRS requires this amount to be reported as taxable income even though no cash is received.
A ($194) incorrectly uses a calculation method that doesn't apply to zero-coupon bond accretion. C ($386) appears to use an incorrect percentage or formula, possibly confusing the total discount with annual accretion. D ($500) incorrectly calculates imputed interest based on the face value ($10,000 × 5% = $500) rather than the purchase price; imputed interest in year one is based on the discounted purchase price, not the maturity value. In subsequent years, the imputed interest increases as the bond's book value accretes toward $10,000.
Phantom income calculations appear on the Series 65 exam to test understanding of zero-coupon bond taxation. Investors must pay taxes annually on imputed interest despite receiving no cash, creating a significant tax liability that makes zero-coupon bonds unsuitable for taxable accounts. This calculation skill is essential for client education and tax planning.
All of the following statements about zero-coupon bonds are accurate EXCEPT
D is correct (the EXCEPT answer). Zero-coupon bonds do NOT provide periodic income; by definition, they make no coupon payments during the holding period. The investor receives no cash until maturity, when the full face value is paid. This is the fundamental characteristic that distinguishes zero-coupon bonds from traditional bonds.
A is accurate: zero-coupon bonds have higher duration than coupon bonds of the same maturity, making them significantly more sensitive to interest rate fluctuations. A 20-year zero-coupon bond has a duration of approximately 20 years, while a 20-year coupon bond might have a duration of 12-14 years. B is accurate: because there are no coupon payments to reinvest, zero-coupon bonds eliminate reinvestment risk entirely; the yield to maturity is locked in if held to maturity. C is accurate: the IRS requires investors to pay annual taxes on imputed interest (phantom income) even though no cash is received, making these bonds tax-inefficient in taxable accounts.
The Series 65 exam tests comprehensive understanding of zero-coupon bond characteristics to ensure advisers can properly explain these instruments to clients. The lack of periodic income is a critical limitation that makes zero-coupon bonds unsuitable for investors seeking current cash flow, such as retirees.
A client is considering purchasing zero-coupon municipal bonds for their taxable investment account. Which of the following statements about this investment are accurate?
1. The investor will receive no cash payments until the bonds mature
2. The imputed interest will be exempt from federal income taxation
3. The bonds will have lower interest rate sensitivity than coupon municipal bonds with the same maturity
4. The investor faces no reinvestment risk if holding the bonds to maturity
C is correct. Statements 1, 2, and 4 are accurate.
Statement 1 is TRUE: Zero-coupon bonds, by definition, make no periodic interest payments. The investor receives no cash until maturity, when the full face value is paid.
Statement 2 is TRUE: Zero-coupon municipal bonds combine the tax advantages of municipal bonds with zero-coupon mechanics. The imputed interest on municipal zero-coupon bonds is exempt from federal income taxation (and potentially state/local taxes if issued in the investor's state), eliminating the phantom income tax problem that makes taxable zero-coupon bonds unsuitable for taxable accounts.
Statement 3 is FALSE: Zero-coupon bonds have HIGHER interest rate sensitivity (longer duration) than coupon bonds with the same maturity, not lower. A 20-year zero-coupon bond has a duration near 20, while a 20-year coupon municipal bond might have a duration of 12-15 years, making the zero-coupon bond significantly more volatile when rates change.
Statement 4 is TRUE: With no coupon payments to reinvest, zero-coupon bonds eliminate reinvestment risk entirely. The yield to maturity is locked in at purchase, assuming the bond is held to maturity and doesn't default.
The Series 65 exam tests understanding of how zero-coupon mechanics interact with other bond features, such as municipal tax exemption. Zero-coupon municipal bonds are particularly attractive because they solve the phantom income tax problem while maintaining the predictable, locked-in return that makes zero-coupon bonds suitable for target-date planning. Understanding duration differences is critical for managing interest rate risk in client portfolios.
💡 Memory Aid
Remember "ZERO = Z.E.R.O." for zero-coupon bonds: Zero payments until maturity (no coupons), Extreme interest rate sensitivity (long duration), Return from discount to par (not coupons), Owe taxes on phantom income annually (unless tax-deferred account). Picture buying a bond for 50 cents that pays you $1 at maturity, but the IRS taxes you every year on money you haven't received yet. Best for tax-deferred accounts and target-date goals (college, retirement).
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