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.
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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.
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 1.50% APY.
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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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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