What is a Zero-Coupon Certificate of Deposit (CD)?

A zero-coupon CD is one kind of certificate of deposit (CD) that doesn’t pay interest throughout its term. On the other hand, zero-coupon CDs yield a profit because they are sold for less than face value. This implies that the investor will get a larger payout when the CD matures than they initially invested. Even though no interest payments were received before the maturity date, this gives the investor a return on investment (ROI).

Conventional CDs, on the other hand, pay interest periodically throughout their term, often once a year. Risk-averse investors like regular and zero-coupon CDs because they provide guaranteed principal protection. That said, investors who are not very concerned with producing cash flow throughout the investment period can find zero-coupon CDs particularly appealing.

How Zero-Coupon CDs Work

A zero-coupon CD is offered at a significant discount, but it pays out its whole face value when it matures. If, for example, a $100 zero-coupon CD were to be sold for just $90, investors would have made a profit of $10 at the end of the term. The fact that these investments have no yearly interest payments, often known as “coupons,” gives rise to the phrase “zero coupons.”

CDs with zero coupons are regarded as low-risk investments. Over a defined period, investors are promised an inevitable return as long as they don’t take their cash before the end of the term. Additionally, because banks often issue zero-coupon CDs, the Federal Deposit Insurance Corporation (FDIC) will guarantee them as long as it is an FDIC-insured bank.

The primary benefit of zero-coupon certificates of deposit is their propensity to provide greater returns than conventional CDs. They do, however, have some drawbacks. For example, taxable income is generated by the interest accumulating each year on zero-coupon CDs, even if the funds are deposited at the end of the term. This is true even though the CDs do not pay interest annually. This implies that investors need to make advance plans to guarantee they have enough money set aside to pay these taxes. Zero-coupon CDs have one potentially serious disadvantage besides treatment: they may be set up as callable assets. This implies that the issuing bank may call them back before they mature and reissue them at a lower interest rate. Naturally, zero-coupon CDs do not provide yearly interest payments, which may be a drawback for investors who prioritize cash flow.

An Actual Zero-Coupon CD Example

For example, suppose you are selling a $5,000 face-value, five-year zero-coupon CD for $4,000. The investor has to spend $4,000 to obtain the CD. They will get the whole $5,000 after five years. However, no interest will be paid on the instrument during this period.

The $1,000 investment profit equates to $200 in accumulated income over five years. Investors may see this as being comparable to an annual interest rate of 5%, with the crucial disclaimer that the money will be collected after the fifth year. Additionally, the investor must ensure they have enough money set aside in the years before the maturity date to meet the tax burden associated with the accumulated interest since it is deemed taxable income.

Considering all this, an investor may find this a compelling investment if they do not need consistent cash flow throughout the five years and competing fixed-income assets pay less than 5%.

Conclusion

• A zero-coupon CD is a type of CD that does not pay interest throughout its term.
• Instead, the investor is compensated by receiving a face value upon maturity higher than the instrument’s purchase price.
• Zero-coupon CDs generally offer higher returns than traditional CDs to compensate the investor for the lack of interest income.