security that makes no periodic interest payments but instead is sold at a deep discount from its face value. The buyer of such a bond receives the rate of return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date. For tax purposes, the Internal Revenue Service maintains that the holder of a zero-coupon bond owes income tax on the interest that has accrued each year, even though the bondholder does not actually receive the cash until maturity. The IRS calls this interest imputed interest. Because of this interpretation, many financial advisers recommend that zero-coupon securities be used in Individual Retirement Account or keogh accounts, where they remain tax-sheltered.
There are many kinds of zero-coupon securities. The most commonly known is the zero-coupon bond, which either may be issued at a deep discount by a corporation or government entity or may be created by a brokerage firm when it strips the coupons off a bond and sells the corpus and the coupons separately. This technique is used frequently with Treasury bonds, and the zero-coupon issue is marketed under such names as CATS (Certificate of Accrual on Treasury Securities), tiger(Treasury Investors Growth Receipt) or strip (separate trading of registered interest and principal of securities). Zerocoupon bonds are also issued by municipalities. Buying a municipal zero frees its purchaser of the worry about paying taxes on imputed interest, since the interest is tax-exempt. Zero-coupon certificates of deposit and zero mortgages also exist; they work on the same principle as zero-coupon bonds-the CD holder or mortgage holder receives face value at maturity, and no payments until then. Zero-coupon securities based on Collateralized Mortgage Obligation bonds are called Z-tranche bonds. Some mutual funds buy exclusively zerocoupon securities, offering shareholders a diversified portfolio that will mature in a particular year.
Zero-coupon securities are frequently used to plan for a specific investment goal. For example, parents knowing their child will enter college in 10 years can buy a zero that will mature in 10 years, and thus be assured of having money available for tuition. People planning for retirement in 20 years can buy 20-year zeros, assuring them that they will get the money when they need it.
Because zero-coupon securities bear no interest, they are the most volatile of all fixed-income securities. Since zero-coupon bondholders do not receive interest payments, zeros fall more dramatically than bonds paying out interest on a current basis when interest rates rise. However, when interest rates fall, zero-coupon securities rise more rapidly in value than full-coupon bonds, because the bonds have locked in a particular rate of reinvestment that becomes more attractive the further rates fall. The greater the number of years that a zero-coupon security has until maturity, the less an investor has to pay for it, and the more leverage is at work for him. For instance, a bond maturing in 5 years may double, but one maturing in 25 years may increase in value 10 times, depending on the interest rate of the bond.
interest assumed on a noninterest-bearing note, including discounted or zero-coupon instruments, or on a note with an unrealistically low interest rate. It applies to both notes payable and notes receivable. The imputed interest rate is the one the borrower would normally incur in a similar transaction. Assume a $10,000 one-year noninterest- bearing note payable was issued on 1/1/2005. It would be unrealistic to believe that someone would take a one-year note without interest. Thus, interest must be imputed, to arrive at the present value of the note on 1/1/2005. If we use a 10% imputed interest rate, the present value of the note is $9091 ($10,000/1.10). Hence, the note consists of a principal portion of $9091 and an imputed interest portion of $909.
