WHAT ARE ZERO COUPONS?

Like bonds, zero coupon securities are debt instruments issued by the U.S. Treasury, municipal governments, corporations, or brokerage firms.

With traditional bonds, the coupon rate is the rate of annual interest the issuer pays to the bondholder.

The "zero" in "zero coupon," then, means that this kind of security does not make any interest payments, as bonds do.

Why would anyone go for that deal?

Because zero coupons are issued at discounts usually far below the face value, or par, of the security. As with bonds, the issuer pays the holder the par value when the instrument reaches its maturity date.

So, while your zero coupon will not make regular interest payments while you hold it, it will pay out much more than you paid for it when it matures. While this growing value appears to be similar to the capital appreciation of an investment in stocks, it is essentially compounding interest income, not a capital gain.

There is a growing variety of zero coupon instruments (or "zeros" for short). Let's look at the basic types next.