Zero coupon bonds, sometimes called strip bonds, are bonds that do not pay a regular interest rate during the life of the bond. Instead, investors buy the bonds at a discount from their face value, for example paying $700 for a $1,000 bond. When the bond matures, the investor can redeem the bond for its full face value. Zero coupon bonds are a long-term investment -- most do not mature for 10 or 15 years, meaning they are best for people looking for safer ways to save for long-term goals, such as retirement or a child's college tuition.
Set your savings goals. Zero coupon bonds are a stable, long-term investment, and as such, they are best suited to people looking for a conservative alternate to the stock market. If you're looking to make high returns quickly, zero coupon bonds may not be the best investment for you.
Buy the bonds through a tax-deferred retirement account to defer the income taxes on the interest income. Although you do not receive the interest on zero coupon bonds directly each year, you can still be taxed on the “phantom” interest that accrues each year. If you purchase the bonds through a retirement account, you'll only pay the tax on the interest once you retire.
Buy municipal zero coupon bonds from the state or city where you live to avoid paying federal income tax on the phantom interest. Municipal bonds are issued by the state, county or other local government. You can also avoid paying tax on the interest by buying corporate zero coupon bonds that have tax-exempt status.
Save on taxes by using the zero coupon bonds for your child's education. If the bonds will be used for education, you're allowed to place the bonds in your child's name. The interest on the bonds is then taxable at the child's rate, which will usually be much lower than your tax rate.
Pay as little of the face value of your bond as you can to maximize your profit. For example, if a bond is worth $1,000 and you buy it for $800, you'll earn $200 in interest when the bond matures. But if you pay just $500 for the bond, you'll earn $500 at maturity. Zero coupon bond prices can fluctuate a great deal. Wait until the bond prices reach the amount you want to pay.
Buy zero coupon bonds from a full-service or discount broker. The face value of the bond will be the same no matter which broker you use. To save money, shop around for a broker who charges a lower markup, or commission.
- Jupiterimages/Comstock/Getty Images