How to Make Money With Zero-Coupon Treasuries
A zero-coupon Treasury bonds may seem like a strange type of investment. Generally, investors earn money from bonds that pay a fixed interest rate, also known as the coupon rate. Zero-coupon Treasuries, on the other hand, pay no regular fixed interest rate. The way you earn a return with zero-coupon bonds is by buying them at a discount. Upon the maturity of the bond, you receive the face value of the bond, also known as the par value. The difference between the amount you paid for the bond and the amount you receive at maturity is your total return.
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Instructions
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Hold your bonds until maturity. Because zero-coupon bonds do not pay regular interest, the most likely way to make money on them is to hold them until they mature. Every zero-coupon Treasury has a stated maturity date, so you know the exact day you will receive your money. You also know the exact amount you will receive, as zero-coupon Treasuries pay $1,000 per bond at maturity. Any Treasury bond, including zero-coupon bonds, carries very little risk of default, as they all are backed by the "full faith and credit" of the U.S. government. The way to make money on these bonds is to buy them at less than their maturity value of $1,000, then wait until maturity to receive your $1,000.
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Sell your bonds if interest rates fall. If you can't wait until maturity, you can also make money on zero-coupon Treasury bonds if market interest rates fall. While the mathematics behind interest rates and bond prices can be complicated, all you need to understand is that when interest rates fall, bond prices rise. Zero-coupon bonds tend to fluctuate even more in price than regular interest-paying bonds, so a fall in interest rates usually makes the value of a zero-coupon Treasury rise more than an interest-paying bond with the same maturity date. If interest rates have fallen since you bought your bond, you can usually sell it at a profit.
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Buy in a tax-deferred account. While you won't make any money buy purchasing a zero-coupon Treasury bond in a tax-deferred account, you can avoid paying current income taxes on the bond. Even though zero-coupon Treasuries do not pay interest directly, you still have to pay tax on the so-called "phantom income" that a zero-coupon Treasury creates every year. Essentially, "phantom income" is the approximate amount that the bond rises in value every year as it heads toward its maturity price of $1,000. If you buy a zero-coupon Treasury in a tax-deferred account, such as an IRA, you do not have to pay any tax on your bond until you take the money out of your IRA.
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