how zero coupon cds work
a zero coupon cd is a cd sold at a steep discount which nevertheless pays out the full face value at maturity for instance a zero coupon cd with a face value of 100 might be sold for only 90 meaning investors would receive a profit of 10 upon reaching the end of the term the term zero coupon comes from the fact that these investments have no annual interest payments which are also referred to as coupons zero coupon cds are considered a low risk investment provided they do not withdraw their funds before the end of the term investors are guaranteed a specified return over a predetermined time period and because zero coupon cds are often issued by banks this means they are backed by the federal deposit insurance corporation fdic as long as the bank issuing the cd is insured by the fdic the main advantage of zero coupon cds is that they tend to offer slightly higher returns as compared to traditional cds however they also have their disadvantages for instance even though zero coupon cds do not pay interest each year the accrued interest earned each year is considered taxable income even though those funds are not actually received until the end of the term this means that investors must plan ahead to ensure that they have sufficient funds available in order to cover these taxes aside from their treatment the other potentially significant drawback of zero coupon cds is that they can be structured as callable investments this means that they can be called back by the issuing bank prior to maturity and then reissued at a current lower interest rate and of course zero coupon cds do not offer annual interest payments which might be inconvenient for cashflow oriented investors real world example of a zero coupon cdto illustrate consider the case of a 5 year zero coupon cd with a face value of 5 000 being sold for 4 000 to purchase the cd the investor only needs to pay 4 000 at the end of 5 years they will receive the full 5 000 in the meantime however no interest will be paid on the instrument in this case the 1 000 profit received on the investment works out to accrued income of 200 per year for 5 years from the investor s perspective this can be seen as equivalent to a 5 annual interest rate with the important caveat that those funds will not actually be received until the end of year 5 also because the accrued interest is considered taxable income the investor will need to ensure they have sufficient funds available to cover that tax expense in the years prior to the maturity date taking all of this into consideration an investor might consider this to be an attractive investment to the extent that alternative fixed income investments are yielding less than 5 and if the investor is not in need of regular cashflow during the 5 year term 