A certificate of deposit (CD) that can be purchased at a deep discount to its par value. At maturity, its holder can redeem it at that value (value at maturity is equal to par value). This certificate pays no interest over the course of its life: its coupon or periodic interest payment is zero, and hence the name “zero-coupon”, or zero interest payments. For example, an investor might purchase a 7-year certificate whose par value is USD 20,000 for a current price of USD 12,000. Over the term of this certificate, the holder will receive no interest. However, at maturity the investor can get the full par value of the certificate in addition to the accrued interest. In other words, the total gains the investor would earn at maturity are:
Total gains = (par value – discount value) + accrued interest
Suppose accrued interest is USD 500, then:
Total gains = (20,000 – 12,000 ) + 500
Total gains = USD 8,500
A zero-coupon certificates has its drawbacks/ disadvantages:
First, usually it is a long-term investment and no money can be earned until it matures. Second, earnings accrue year to year, though the holder gets nothing. Each year, taxes have to be paid on the accrued earnings, while on a cash-basis the holder receives no income on the invested funds. Year in year out, the holder has a bigger tax base and consequently a heavier tax bill.
At maturity, gains have to be adjusted against taxes to arrive at the actual return.
