What Are Zero-Coupon Bonds and "Strips"?

Zero-coupon bonds, or zeros, are sold at a discount to face value. Interest is compounded during the term of the bond, but unlike other bonds, those interest payments aren't made until the bond matures.

With zero-coupon bonds, an investor buys a $1,000 bond for considerably less than that amount. There are no payments received until the bond matures - perhaps as far into the future as 30 years. However, investors can buy and sell the bonds prior to maturity -- realizing a gain or loss depending on how prices have changed since the original purchase.

The most popular forms of zero-coupon bonds are sold by the U.S. government. U.S. Savings Bonds such as the EE Series are zero-coupon investments. Treasury bills, which mature in one year or less, are also zero-coupon investments.

Another form of zero-coupon investment is called a "strip." Strips, or Separate Trading of Registered Interest and Principal Securities, are created from traditional, interest-paying bonds. A financial institution buys the bond and then "strips" out the interest payment -- creating two distinct investments: a zero-coupon bond and a collection of interest coupons. They can be sold separately.

Why Buy a Zero-Coupon Bond?

Institutional investors such as pension funds and insurance companies often like long-maturity zeros because of a complicated valuation concept known as duration. Zeros have a high duration, which means they can be used to mitigate interest rate risks associated with money that must be paid in the future (insurance policies, pensions, etc.)

But zeros may also appeal to some average investors.

1. Zeros are inexpensive: Say you're looking to set aside money for retirement in 30 years. For every $1,000 you'd want to have then, you must pay $1,000 today for an interest-paying bond. As an alternative, you can "lock in" that future $1,000 by buying a zero-coupon today for closer to $250.
2. Most zeros are very safe. The most popular form of zero-coupon bonds are U.S. Treasury Strips. Given that they are created from government debt offerings that are backed by the full faith and credit of the U.S. government, the risk of default is nil.

On the Other Hand ... Reasons to Avoid Zeros

There are also three good reasons for the average investor to think twice before buying zeros.

1. You'll owe taxes on the interest before you receive the interest. A quirk in U.S. tax law makes the holder of a zero responsible for taxes on interest as it accrues. So the owner must pay taxes every year on interest that he won't receive until the bond matures.
2. The prices of zeros fluctuate wildly in the secondary market. If you have to sell before maturity, you could lose money.
3. Locking yourself into a zero exposes you to inflation risk. If you don't sell before maturity, the money you collect at the end of the term may have lost some of its value. In other words, your investment may not keep up with inflation.