When you purchase a bond issued by a corporation or government, you are lending the issuer money. Typically you can expect to earn a specific rate of interest, or yield, on your loan and receive regular payments, often on a semiannual basis.

You also can expect the principal, or face value, of the bond to be paid back to you at the end of the period you have agreed to lend your money, which is the bond's maturity date.

But the process is different when you invest in securities known as zero-coupon bonds.

What's a zero-coupon bond?

U.S. Treasury zero-coupon bonds are securities that:

  • are sold at a deep discount from their face value
  • do not pay interest

The return on a zero-coupon bond comes from the difference between the purchase price of the bond and its value at its maturity date.

Zero-coupon bond funds

Zero-coupon bond funds invest in individual zero-coupon bonds. This type of fund can provide a relatively dependable return if held to maturity. Prior to maturity, a zero-coupon bond fund may have dramatic share price fluctuation in response to changing interest rates; generally, as interest rates rise, bond prices fall. Shares sold before maturity may produce significant losses or gains.

Some investors prefer zero-coupon bond funds to save for specific goals, such as retirement or a child's college education, because they can estimate in advance approximately how much these investments will be worth when they mature. However, there is no guarantee the fund shares will reach their anticipated value at maturity.

Annual taxes on accrued interest

Although you do not receive regular interest payments from zero-coupon bonds, the IRS requires you to pay income tax on the accrued interest each year as if it had been paid to you. This type of interest is referred to as "imputed interest."

Bonds and bond funds can help you create a diversified portfolio of investments to help reach your goals, though diversification cannot ensure against loss. Analyze your asset allocation and learn more about the ways bonds can fit in your investment plan.

IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.

This information is for educational purposes only and not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.