Zero-Coupon Bonds
Zero-coupon bonds can be issued by companies, government agencies, or municipalities. Known as zeros, these bonds do not pay interest periodically as most bonds do. Instead, they are purchased at a discount and pay a higher rate (both interest and principal) when they reach maturity.
Don't buy zeros (or zero-coupon bonds) for liquidity in your portfolio. As for taxes, despite the fact that you do not receive any interest payments, you need to report the amount the bond increases each year.
The interest rate is locked in when you buy the zero-coupon bond at a discount rate. For example, if you wanted to buy a five-year $10,000 zero in a municipal bond, it might cost you $7,500, and in five years you would get the full $10,000. The longer the bond has until it reaches maturity, the deeper the discount will be. Zeros are the best example of compound interest. For example, a twenty-year zero-coupon bond with a face value of $20,000 could be purchased at a discount, for around $7,000. Since the bond is not paying out annual or semiannual dividends, the interest continues to compound, and your initial investment will earn the other $13,000. The interest rate will determine how much you will need to pay to purchase such a bond, but the compounding is what makes the discount so deep.
