Action alert: Understand the discount, imputed interest rate, and the phantom tax.
Be aware that the market price of zero coupon bonds can be more volatile than regular bonds. The appeal of these bonds is their discounted purchase price and sometimes higher yields. On a zero coupon bond, the discount when you buy the bond represents the interest you will be paid for the full term of the bond. For example, a zero coupon bond with a $10,000 face value maturing in 15 years could be purchased at $5,550, a $4,450 discount which reflects imputed interest of $4,450 at an interest rate of 4%. If interest rates increase to 7%, your zero coupon bond will drop substantially in value, to about $3,620, a loss of $1,930 or 35% on your original investment of $5,550.
Another caution: Zero coupon bonds carry what is called a “phantom tax”: You pay income taxes on the accrued interest each year even though you don’t receive the interest. If the bonds are being held in a tax-sheltered retirement account, that’s not a problem. But if you need current income or the bonds will be in a taxable account, you may want to stay away from zero coupon bonds.