Zero-coupon bonds do not pay interest during the bond's life. Since most investors purchase bonds to receive periodic interest income, this may seem like a contradiction. However, some investors desire the fixed return without the periodic receipt of interest payments. Zero-coupon bonds were designed to meet that need.

What are the major characteristics of zero-coupon bonds? Zero-coupon bonds are sold at a deep discount from face value. Since the bonds do not pay interest during the bond's life, your return results from the bond's price gradually increasing from the discounted value to the face value at maturity. Maturity dates range from six months to 30 years.

The bond's interest rate is locked in at purchase, but no interest is paid until maturity. Instead of receiving semiannual interest payments, your principal earns the stated interest rate compounded over the bond's life. When the bond matures, you will receive both the principal and interest - the bond's face value.

What types of zero-coupon bonds exist? You can purchase corporate, U.S. Treasury, or municipal zero-coupon bonds. Since you don't receive any of your investment until maturity, choose a zero-coupon bond with a high credit rating. U.S. Treasury zeros are the safest zeros, since the payment of principal and interest is guaranteed by the U.S. government if held to maturity. However, many corporate and municipal zero-coupon bonds are issued with high credit ratings.

What are the advantages of zero-coupon bonds? Zeros have several unique features that may be attractive to investors:

• Your principal earns the stated interest rate compounded over the entire period the bonds are outstanding.
• You can purchase zero-coupon bonds to mature at a specific time for the amount needed, providing a convenient way to fund known expenses.
• For a relatively small initial investment, you can purchase a bond that will pay a much larger amount at a later date.

How are zero-coupon bonds taxed? The yearly growth in the value of the zero, called accretion, is considered interest income for tax purposes, even though you don't actually receive the money. You can avoid these taxes by purchasing zero-coupon municipal bonds, whose accretion is not taxable. Or you can purchase zeros for tax-sheltered accounts, such as 401(k) plans or individual retirement accounts. Then, taxes will be deferred until the money is withdrawn.

How do interest rate changes impact the value of zero-coupon bonds? Like other fixed-income securities, a zero-coupon bond's price moves up when interest rates fall and down when interest rates rise. However, zeros are affected much more dramatically by movements in interest rates. A general rule of thumb is that a 1% movement in interest rates will adjust a zero-coupon bond's market value by approximately 1% for every year left to maturity. By holding the bond to maturity, however, you will receive the entire face value. Because of the possibility of large fluctuations, it is generally recommended that you hold zero-coupon bonds until maturity.