Key Differences Between Zero Coupon CD and Bonds
The major difference between a zero-coupon CD and a bond is that CDs don't generate interest payments or coupons, while a bond provides regular interest for the bondholder. That's why this special class of bonds is called zero-coupon CDs. This simple difference between the two investments causes various consequences that favor certain types of investors.
Understanding the Two Investment Processes
Holders of zero-coupon bonds don't receive any coupons, or interest payments, over the life of the investment. In return, investors can buy zero coupon bonds at a large discount on the face value. They essentially earn their return as the difference between the discounted price and the face value of the zero coupon bond.
Regular bonds, however, provide regular interest payments to the bondholder, and at maturity, the bondholder receives the face value of the bond. That can seem to be a bigger advantage, but practically, the yield of zero coupon bonds is usually higher than ordinary bonds. Coupon-paying bonds usually trade near their face value, but zero coupon bonds trade based on how much interest, or equity, has accrued to enhance the value of the deeply discounted initial price.
The maturity date of any bond depends on whether it's a short-term or long-term investment. Short-term zero coupon bonds usually mature within a year and are called bills. Long-term zero-coupon CDs usually mature in 10 to 15 years. That makes them ideal for retirement savings and financing college educations. Zero-coupon CDs are also useful to give children or grandchildren a stake for business or starting a family.
Investors who need to generate a steady income find little use for zero coupon CDs because they not only won't receive interest payments for up to two decades but also will have to pay taxes on accrued interest that they don't receive until the CD matures. However, zero coupon bonds can be held in tax-deferred retirement accounts so that the taxes are deferred until the investor begins to withdraw funds.
Pros and Cons of Zero Coupon CDs
What We Like
Higher interest rates than other bonds.
More secure as they are issued by large financial institutions.
Ideal for investing with specific goals as you know how much investment return to expect.
What We Don't Like
You have to pay taxes on "phantom" interest that accrues to your account.
Subject to higher default rates.
One of the big advantages of zero coupon CDs is that they generally carry higher interest rates than other bonds. Corporations need to attract investors with a long-term investment vehicle that doesn't generate interest payments, so it's important to offer them a higher cumulative return on their investments.
Zero coupon bonds are considered more secure than other bonds simply because they are issued by large banks and other financial institutions. As CDs, the investment is insured by the Federal Deposit Insurance Corporation, or FDIC, up to $250,000. That's ideal for the small investor saving for a predefined financial goal.
Zero-coupon CDs also are ideal for investing with specific goals in mind such as paying for college educations or funding a comfortable retirement. You get the advantage of knowing exactly how much your investment will return.
One of the biggest disadvantages of zero coupon bonds is that you have to pay taxes on "phantom" interest that accrues to your account even though you don't receive the actual interest until later. The bonds—with higher interest rates—are also subject to higher default rates. The principals keep the money and interest to use as they please, and many don't make arrangements to pay off the debts when due. The companies can also pay off their zero-coupon CDs with accrued interest early before the term is over, so the strategy isn't always foolproof.
No investment is.
Pros and Cons of Bond Investing
What We Like
More stable returns––regular interest payments, less volatility.
Ideal for investors who want to earn regular interest until their bond matures.
What We Don't Like
Lower return on investment than stocks or zero-coupon CDs.
Require investing a larger amount of money than other investments
Less liquid than other investments
Bond investing can be attractive to many investors because bonds tend to generate more stable returns. You receive regular interest payments, and bonds don't fluctuate as widely as stocks. Treasury bonds can provide liquidity and stability for nervous investors. Bondholders get paid before stockholders if the investment defaults and is liquidated.
Bonds have clear ratings that range from a AAA rating, the highest, to a C-rating, the lowest. Bond investing is ideal for investors who want to earn regular interest until their bond matures. It's perfect for retirement investing and earning regular income from a financial windfall or savings at a higher rate than banks offer.
The cons of bond investing include earning a lower return on your investment when compared with investing in stocks and zero coupon CDs. Interest rates on long-term bonds can fluctuate dramatically if interest rates rise and fall. Returns are fixed, and you might have to forego higher earnings in a strong financial market. Bonds usually require investing a larger amount of money than other investments. Bonds are generally less liquid than other investments—especially high-interest bonds issued by smaller companies—which are often called junk bonds.
Investing in bonds allows you to choose from corporate and municipal bonds. The former may be more volatile but earn higher returns. Municipal bonds are more stable and less likely to fluctuate wildly. Municipal and U.S. Treasury bonds often have built-in tax advantages. Zero coupon bonds offer higher interest and are the best option for saving for specific financial goals. You know exactly how much you'll receive if you can manage the phantom tax payments over the life of the investment.