Series 7: 4.9.3. Zero Coupon Bonds

4.9.3. Zero Coupon Bonds

Treasury bills, STRIPS, and corporate zeros are all considered zero coupon bonds because they do not pay annual interest over the life of a bond. Instead, each is bought at a deep discount and matures at the bond’s par value. Even though the bond does not pay interest payments, the IRS considers the amount of discount to be taxable interest. The taxpayer must divide the discount by the bond’s total maturity to come up with the bond’s annual “phantom” interest. The bondholder will then pay taxes on this phantom interest at her ordinary tax rate. She will also adjust the cost basis of the bond by adding the annual phantom amount each year. The adjusted cost basis of the bond will accrete (increase) each year until it is equal to the par value at maturity.

If an investor sells a zero coupon bond before it matures, she will usually be subject to a capital gain or loss. To determine the amount of gain or loss, the bond’s adjusted cost basis at the time of sale is subtracted from the sale price. If the sale price is higher than the bond’s cost basis, then the positive difference is a capital gain; if the sale price is lower than the adjusted cost basis, then the negative difference is a capital loss.

Example: Sally buys a $1,000 zero for $750. It will mature in five years. The amount of the discount is $250. Annual phantom income is $50 ($250 / 5 = $50). The adjusted cost basis will