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A zero-coupon certificate of deposit or zero-coupon CD is a type of CD that’s purchased at a discount and pays out interest at maturity. Zero-coupon CDs can offer higher yields than standard CDs for investors who have the patience to wait until maturity to collect their original deposit and the interest earned.

Zero-coupon certificates of deposit are similar to bonds, in that both are considered low-risk, fixed-income instruments, but they serve different purposes in a portfolio. Understanding how a zero-coupon CD works can make it easier to decide if it’s a good investment.

What Is a Zero-Coupon CD?

To understand zero-coupon CDs, let’s recap how a certificate of deposit works. A CD account, also referred to as a time-deposit or term-deposit account, is designed to hold money for a specified period of time. While the money is in the CD, it earns interest at a rate determined by the CD issuer — and the investor cannot add to or withdraw from the account.

CDs are FDIC or NCUA insured when held at a member bank or credit union. That means deposits are insured up to $250,000.

CDs are some of the most common interest-bearing accounts banks offer, alongside savings accounts and money market accounts (MMAs).

A zero-coupon certificate of deposit does not pay periodic interest. Instead, the interest is paid out at the end of the CD’s maturity term. This can allow the purchaser of the CD to potentially earn a higher rate of return because zero-coupon CDs are sold at a discount to face value, but the investor is paid the full face value at maturity.

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By comparison, traditional certificates of deposit pay interest periodically. For example, you might open a CD at your bank with interest that compounds daily. Other CDs can compound monthly. Either way, you’d receive an interest payment in your CD account for each month that you hold it until it matures.

Once the CD matures, you’d be able to withdraw the initial amount you deposited along with the compound interest. You could also roll the entire amount into a new CD if you’d prefer.

Remember: Withdrawing money from a CD early can trigger an early withdrawal penalty equal to some or all of the interest earned.

How Do Zero-Coupon CDs Work?

Ordinarily when you buy a CD, you’d deposit an amount equal to or greater than the minimum deposit specified by the bank. You’d then earn interest on that amount for the entirety of the CD’s maturity term.

With zero-coupon CD accounts, though, you’re purchasing the CDs for less than their face value. But at the end of the CD’s term, you’d be paid out the full face value of the CD. The discount — and your interest earned — is the difference between what you pay for the CD and what you collect at maturity. So you can easily see at a glance how much you’ll earn from a zero-coupon CD investment.

In a sense, that’s similar to how the coupon rate of a bond works. A bond’s coupon is the annual interest rate that’s paid out, typically on a semiannual basis. The coupon rate is always tied to a bond’s face value. So a $1,000 bond with a 5% interest rate has a 5% coupon rate, meaning a $50 annual payout until it matures.

Real World Example of a Zero-Coupon CD

Here’s a simple example of how a zero-coupon CD works. Say your bank offers a zero-coupon certificate of deposit with a face value of $10,000. You have the opportunity to purchase the CD for $8,000, a discount of $2,000. The CD has a maturity term of five years.

You wouldn’t receive any interest payments from the CD until maturity. And since the CD has a set term, you wouldn’t be able to withdraw money from the account early. But assuming your CD is held at an FDIC- or NCUA-member institution, the risk of losing money is very low.

At the end of the five years, the bank pays you the full $10,000 face value of the CD. So you’ve received $400 per year in interest income for the duration of the CD’s maturity term — or 5% per year. You can then use that money to purchase another zero-coupon CD or invest it any other way you’d like.

Tips When Investing in a Zero-Coupon CD

If you’re interested in zero-coupon CDs, there are a few things to consider to make sure they’re a good investment for you. Specifically, it’s important to look at:

•   What the CD is selling for (i.e., how big of a discount you’re getting to its face value)

•   How long you’ll have to hold the CD until it reaches maturity

•   The face value amount of the CD (and what the bank will pay you in full, once it matures)

It’s easy to be tempted by a zero-coupon certificate of deposit that offers a steep discount between the face value and the amount paid out at maturity. But consider what kind of trade-off you might be making in terms of how long you have to hold the CD.

If you don’t have the patience to wait out a longer maturity term, or you need the money in the shorter term, then the prospect of higher returns may hold less sway for you. Also, keep in mind what kind of liquidity you’re looking for. If you think you might need to withdraw savings for any reason before maturity, then a standard CD could be a better fit.

Comparing zero-coupon CD offerings at different banks can help you find one that fits your needs and goals. You may also consider other types of cash equivalents, such as money market funds or short-term government bonds if you’re looking for alternatives to zero-coupon CDs.

Recommended: How to Invest in CDs: A Beginner’s Guide

Pros of Zero-Coupon CDs

Zero-coupon CDs have some features that could make them more attractive than other types of CDs. The main advantages of investing in zero coupon certificates of deposit include:

•   Higher return potential than regular CDs

•   Guaranteed returns, since you’re unable to withdraw money before maturity

•   Suited for longer-term goals

•   Can be federally insured

Zero-coupon CDs are low-risk investments, which can make them more appealing than bonds. While bonds are considered low-risk investments generally, if the bond issuer defaults, then you might walk away from your investment with nothing.

A zero-coupon certificate of deposit, on the other hand, does not carry this same default risk because your money is insured up to $250,000. There is, however, a risk that the CD issuer could “call” the CD before it matures (see more in the next section).

Cons of Zero-Coupon CDs

Every investment has features that may be sticking points for investors. If you’re wondering what the downsides of zero-coupon CDs are, here are a few things to consider:

•   No periodic interest payments

•   No liquidity, since you’re required to keep your money in the CD until maturity

•   Some zero-coupon CDs may be callable, which means the issuer can redeem them before maturity, and the investor won’t get the full face value

•   Taxes are due on the interest that accrues annually, even though the interest isn’t paid out until maturity

It may be helpful to talk to your financial advisor or a tax expert about the tax implications of zero-coupon CDs. It’s possible that the added “income” from these CDs that you have to report each year could increase your tax liability.

How to Collect Interest on Zero-Coupon CDs

Since zero-coupon CDs only pay out at interest at the end of the maturity term, all you have to do to collect the interest is wait until the CD matures. You can direct the bank that issued the CD to deposit the principal and interest into a savings account or another bank account. Or you can use the interest and principal to purchase new CDs.

It’s important to ask the bank what options you’ll have for collecting the interest when the CD matures to make sure renewal isn’t automatic. With regular CDs, banks may give you a window leading up to maturity in which you can specify what you’d like to do with the money in your account. If you don’t ask for the money to be out to you it may be rolled over to a new CD instead.

How to Value Zero-Coupon CDs

The face value of a zero-coupon CD is the amount that’s paid to you at maturity. Banks should specify what the face value of the CD is before you purchase it so you understand how much you’re going to get back later.

In terms of whether a specific zero-coupon CD is worth the money, it helps to look at how much of a discount you’re getting and what that equates to in terms of average interest earned during each year of maturity.

Purchasing a $10,000 zero-coupon CD for $8,000, for example, means you’re getting it at 20% below face value. Buying a $5,000 zero-coupon CD for $4,500, on the other hand, means you’re only getting a 10% discount.

Of course, you’ll also want to keep the maturity term in perspective when assessing what a zero-coupon CD is worth to you personally. Getting a 10% discount for a CD with a three-year maturity term, for example, may trump a 20% discount for a five-year CD, especially if you don’t want to tie up your money for that long.

The Takeaway

Investing in zero-coupon CDs could be a good fit if you’re looking for a low-risk way to save money for a long-term financial goal, and you’d like a higher yield than most other cash equivalents.

Zero-coupon CDs are sold at a discount to face value, and while the investor doesn’t accrue interest payments annually, they get the full face value at maturity — which often adds up to a higher yield than most savings vehicles. And because the difference between the discount and the face value is clear, zero-coupon CDs are predictable investments (e.g. you buy a $5,000 CD for $4,000, but you collect $5,000 at maturity).

As with any investment, it’s important for investors to know the terms before they commit any funds. For example, zero-coupon CDs don’t pay periodic interest, but the account holder is expected to pay taxes on the amount of interest earned each year (even though they don’t collect it until they cash out or roll over the CD).

If you’re eager to earn a higher rate on your savings, you’ve got a lot of options — including the new high yield bank account with SoFi. With SoFi, you don’t pay management fees or account fees, and if you have direct deposit you can earn 1.25% APY.

FAQ

What is a coupon on a CD?

The coupon on a CD is its periodic interest payment. When a CD is zero coupon, that means it doesn’t pay out interest monthly or annually. Instead, the investor gets the full amount of interest earned paid out to them when the CD reaches maturity.

Is a certificate of deposit a zero-coupon bond?

Certificates of deposit and bonds are two different types of savings vehicles. While a CD can be zero-coupon the same way that a bond can, your money is not invested in the same way. CD accounts also don’t carry the same types of risk that bonds can present.

Are CDs safer than bonds?

CDs can be safer than bonds since CDs don’t carry default risk. A bond is only as good as the entity that issues it. If the issuer defaults, then bond investors can lose money. CDs, on the other hand, are issued by banks and typically covered by FDIC insurance which can make them safer investments.

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SoFi members with direct deposit can earn up to 1.25% annual percentage yield (APY) interest on all account balances in their Checking and Savings accounts (including Vaults). Members without direct deposit will earn 0.70% APY on all account balances in their Checking and Savings accounts (including Vaults). Interest rates are variable and subject to change at any time. Rate of 1.25% APY is current as of 4/5/2022. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet
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Conversations about the stock market are usually tied to comments about its volatility — how frequently share prices go up and down. The choppy nature of share prices can be intimidating to some investors, especially those who are just beginning to invest, nearing retirement, or have been burned by volatility in the past.

Stocks are considered an important part of an investment portfolio and can be a tremendous source of wealth-building for investors. And while there are some lower volatility equities versus higher volatility ones, it’s undeniable that they are a turbulent asset class. That’s why understanding volatility is key to being a good stock investor.

What Is Stock Volatility?

Volatility in the stock market occurs when there are big swings in share prices. Share prices can change quickly for a multitude of reasons. And while volatility in the stock market usually describes significant declines in share prices, volatility can also happen to the upside.

Volatility is often synonymous with risk for investors. That’s because investors generally prefer a steady source of returns rather than an erratic one.

However, volatility in the equity market can also represent significant opportunities for investors. For instance, investors might take advantage of volatility to buy the dip, purchasing shares when prices are momentarily lower.

💡 Recommended: What Types of Stocks Do Well During Volatility?

How to Measure Stock Volatility

Investors often measure an investment’s volatility by its standard deviation of returns compared to a broader market index or past returns. Standard deviation is a calculation determining the extent to which a data point deviates from an expected value, also known as the mean.

A low standard deviation indicates that the data points tend to be close to this expected value. Therefore, an investment with a low standard deviation is considered to have low volatility. A high standard deviation indicates that the data points are spread out over a larger range. For investments, a high standard deviation generally translates to high volatility.

Investors can also monitor the risk in their stock holdings by finding their portfolio beta – its sensitivity to price swings in the broader market. Beta is the financial risk that stems from the entire market and can’t be diversified away.

Another popular measure of tracking volatility is the Cboe Volatility Index, otherwise known as the VIX. The VIX measures the short-term volatility of the U.S. stock market via a formula that uses options trading or the price of call and put contracts based on the S&P 500 Index.

What Causes Market Volatility?

The stock market is known for having boom-and-bust cycles, which is another way of describing volatility.

Long periods of booming share prices tend to drive investors to take on more risk by entering into more speculative positions and buying riskier assets; investors and traders don’t want to miss out on the rally. They thus make themselves more vulnerable to shocks in the financial system, leading to market busts when investors need to sell their holdings en masse when the market is shaky.

💡 Recommended: What Is Flight to Quality? – A look at the herd-like investor behavior.

Regarding individual stocks, events tied to the company’s performance, such as earnings or a product announcement, can drive volatility in its shares. But when it comes to broader market volatility, various causes can trigger more significant swings in share prices, like changes in economic policy or uncertainty over geopolitical events.

For instance, the early stages of the coronavirus pandemic in February and March 2020 brought shockwaves into the markets. As economies across the globe shut down, investors began to sell off risky assets, bringing about high levels of volatility in the financial markets. Governments enacted extraordinary fiscal and monetary stimulus programs to calm this volatility and bring stability to the markets.

Other factors that can drive volatility include liquidity and the derivatives market. Liquidity is the ease with which an asset can be bought and sold without affecting prices. If an asset is tough to unload and gets sold at a significantly lower price, that could inject fear into the market and cause other investors to sell, ramping up volatility.

Separately, there’s sometimes a debate whether derivatives — contracts that are based on an underlying asset — can cause volatility. For instance, in 2020, investors debated whether large volumes of stock options trading caused sellers of the options, typically banks, to hedge themselves by buying stocks, exposing the market to sudden ups and downs when the banks had to purchase or sell shares quickly.

💡 Recommended: What Is a Derivative? A Beginner’s Guide

How to Manage Volatility When Investing

Let’s pretend that it’s 2007, and an investor has money invested in the U.S. stock market. Unfortunately, this investor is facing one of the largest stock market crashes in history. The S&P 500 fell by 57% during this crash.

This drop in the stock market isn’t typical, but it can be traumatic even for the savviest and most experienced investor. So the first step to handling stock market volatility is understanding that there will be some price fluctuation. The second step is to know one’s risk tolerance and financial goals, then invest and readjust a portfolio accordingly.

Generally speaking, higher rewards sometimes come with higher risks. For example, younger investors in their 20s might want to target high growth and be open to more volatile stocks. The reverse is true for someone approaching retirement who wants stable portfolio returns. Some strategies a more cautious investor can take to mitigate volatility in their portfolio. One way is diversification.

Here is why portfolio diversification matters: lower volatility stocks, such as utility or consumer staple companies, can add stability to a stock portfolio. Meanwhile, energy, technology, and consumer discretionary shares tend to be more turbulent because their businesses are more cyclical, or tied to the broader economy.

Another way to diversify one’s portfolio is to add bonds, alternative investments, or even cash. When deciding to add bonds or stocks to a portfolio, it’s helpful to know that the former is generally a less volatile asset class.

How Much Stock Volatility Is Normal?

The average stock market return in the U.S. has been 10% annualized over time. But 10% is an average — share prices returns can be much higher or lower. For example, as measured by the S&P 500, equity prices closed out 2008 down 38%. Then, in 2009, they rallied by 23%.

Past performance is not indicative of future returns, but looking at history can help an investor gauge how much volatility and market fluctuation is normal. Since World War II, the S&P 500 has posted 12 drops of more than 20%. These prolonged downturns of 20% or more are considered bear markets.

Recommended: Bear Market Investing Strategies

The table below shows the S&P 500’s returns from the highest point to the lowest point in a downturn. According to this data, bear markets average a decline of 34%, lasting a little more than a year. Bear markets have occurred as close together as two years and as far apart as nearly 12 years.

The Takeaway

Stock volatility is the pace at which the market moves up or down during a certain period. It’s a complex topic that often sparks debate among investors, traders, and academics about what causes it. While equities are considered an important part of any investment portfolio, they are also known for being volatile, and some degree of turbulence is something most stock investors have to live with.

However, for long-time investors, periods such as when the dot-com bubble burst in the early 2000s and the financial crisis in 2008 are defining moments when market volatility seemed to get out of hand. While such events are rare, investors should make sure to diversify their portfolios, monitor the share prices of their stock holdings, and seek protection when possible.

If an investor wants to pick stocks and exchange-traded funds (ETFs) for their portfolio with no commissions, a SoFi online brokerage account might be a good option. But investing is not something that someone has to do on their own. They might consider help from a professional or robo advisor service, such as SoFi automated investing.

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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
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