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Definition: Zero Coupon Certificate Of Deposit (CD)
Zero-coupon Certificates of Deposits (CDs) are CDs that are purchased at a price that is lower than the face value and that do not pay any interest to the holder until maturity. The interest is accumulated annually and is paid at the time of maturity. Interest is treated as taxable income annually even though no interest payments are actually received until maturity.
For example, a zero-coupon CD with a face value of $10,000 may be purchased at a discount for $7,500 with a maturity period of 4 years. The zero-coupon CD may pay out a higher face value at maturity.
Zero-coupon CDs may have yields that are higher than traditional CDs and this rate is known to the investor at the time of purchase since the zero-coupon CD will return face value at maturity. Since bonds pay a regular interest each period, there is a reinvestment risk associated with the interest payments received. There is no reinvestment risk associated with zero-coupon CDs as no payment is made to the investor until maturity. However, zero-coupon CDs are associated with several drawbacks and risks as well. Even though zero-coupon CDs do not pay any interest until maturity, the annual accumulated interest is treated as taxable income and the investor must make tax payments on the zero-coupon CD every year until maturity. For CDs with high face value, the annual tax payment on the CD will be high. If the zero-coupon CD is callable, the issuer will call back the CD when interest rates fall. Zero-coupon CDs are associated with liquidity risk as no periodic payments are made to the investor.