Three Main Uses Capital Appreciation Tax Deferred Savings Predictability

What is it?
A zero coupon security, or a "stripped bond" is basically a regular coupon paying bond without the coupons. The process of "stripping" or "zeroing" a bond is usually done by a brokerage or bank. The bank or broker stripping the bonds then registers and trades these zeros as individual securities. After the bonds are stripped there are two parts, the principal and the coupons. The interest payments are known as "coupons", and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are bundled and referred to as zero coupon bonds or "zeros".

You can think of a zero coupon security just like a Treasury Bill. Basically you pay a certain amount right now in exchange for the par value of the security at a future date, usually $1,000. For example, you might pay $800 for a zero coupon bond today and in 5 years you will receive the par value $1,000. As you can imagine the longer time to maturity the cheaper you can buy the bond for. This predictability also makes zeros popular, when you buy the security the yield is essentially locked in.

Objectives and Risks:
The basic objective of a zero coupon security is "buy low, sell high". You purchase the bond for a sum of money, and once it reaches maturity you will be paid an even larger sum of money. When interest rates are low, the price of the zero will be higher. The best time to buy a zero is when interest rates are high because the bond will be at a deeper discount.

The one major problem with zeros is that the accumulated return each year is actually considered to be income, and while you don't actually collect that interest until the bond reaches maturity you still have to pay income tax on it. In other words the gains on a zero are not treated as capital gains, instead they are considered to be interest.

How to Buy or Sell it:
Zero coupon securities can be bought through most full service or discount broker, commercial banks, or some other financial intermediaries. The best time to buy a corporate bond is when interest rates are relatively high, this ensures a high return.

Strengths:

zero's can be bought at huge discounts once you buy a zero coupon security you essentially lock-in the yield to maturity.

Weaknesses:

if the company issuing the zero goes bankrupt or defaults then you have everything to lose. Whereas with a regular coupon bond you may have at least gotten some interest payments out of the investment. interest earned on the zero coupon bond is taxed as income (a higher rate) rather than a capital gain.