Key Differences Between Zero Coupon CDs 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.  You essentially earn your 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. 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
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. A few upsides and pitfalls of zero coupon CDs include:
What We Like
are considered more secure than other bonds simply because they are issued by large banks and other financial institutions
You have the advantage of knowing exactly how much your investment will return
Zero coupon CDs is that they generally carry higher interest rates than other bonds
What We Don't Like
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
Bond investing can be attractive to many investors because bonds tend to generate more stable returns. However, there are a few downsides:
What We Like
You receive regular interest payments
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
What We Don't Like
Potential to earn a lower ROI when compared with 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. Muni bonds are more stable and less likely to fluctuate wildly. Muni 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.