What Is a Zero-Coupon CD?
Generally, zero-coupon CDs offer higher interest rates than traditional CDs with comparable terms. The premium exists to compensate investors for the lack of periodic interest payments, which exposes them to a higher degree of interest rate risk.
There are many different types of CDs, but at a high level, they can be classified as either traditional or zero-coupon.
A traditional certificate of deposit makes periodic interest payments throughout its term, and at maturity, an investor’s initial deposit is returned. Conversely, a zero-coupon CD does not make any interest payments. Rather, at maturity, a zero-coupon CD investor is compensated by receiving an amount that exceeds his or her initial deposit.
The maturity date for most CDs is usually between one month and five years, but it could be longer. Generally, the longer the term, the higher the interest rate offered.
How Does a Zero-Coupon CD Work?
The process for investing in a zero-coupon CD is the same as that for a traditional CD. You need to apply in-person or online with the issuing bank or credit union.
Generally, the information requirements are minimal. You will be asked to provide some personal identification and to name a beneficiary for the account. From there, the remaining step is to fund the account, which can usually be done with cash, a check or an electronic transfer.
For illustrative purposes of how a zero-coupon CD works, consider the following example:
- You buy a $10,000 zero-coupon CD on January 1, 2023.
- The term is three years (maturity on January 1, 2026) with an annual percentage yield (APY) of 4.5%.
- The early withdrawal penalty is relatively stringent. It equates to 12 months of interest if the withdrawal is made within one year of opening the account; nine months of interest if the withdrawal is made within two years of opening the account; and six months of interest if the withdrawal is made within one year of maturity.
You keep your money on deposit for the full term. As a result, at maturity, you receive $11,411.66 from the issuing financial institution. This amount, which reflects $1,411.66 of interest income, is computed as follows.
Zero-coupon Proceeds = Initial Investment × (1 + APY) ^ Number of Years
Zero-coupon Proceeds = $10,000 * (1 + 0.0450) ^ 3 = $11,411.66
Some zero-coupon CDs are callable, which means the issuing financial institution has the option to redeem the instrument prior to maturity. In a declining interest rate environment, this is advantageous for the issuer, but disadvantageous for the investor.
Pros and Cons of Zero-Coupon CDs
Zero-coupon CDs are among the safest assets in which you can invest. They exhibit no volatility for your personal finances, and when structured properly, they are insured up to $250,000 for individual accounts and $500,000 for joint accounts.
The government institutions that insure zero-coupon CDs are the Federal Deposit Insurance Corporation (for CDs issued by banks) and the National Credit Union Administration (for CDs issued by credit unions).
Zero-Coupon CDs Pros and Cons
Pros
- Very safe investment
- No volatility
- Insured up to $500,000
Cons
- Illiquidity
- Inflation risk
- Accrual base taxation
Zero-coupon CDs have a few notable disadvantages as well.
As mentioned before, CDs require you to lock up your money for a specified amount of time. Early withdrawals of CDs are subject to penalty, and in some rare cases, loss of principal is possible.
Longer-dated CDs are also exposed to inflation risk, which is the possibility of experiencing a surge in the prices of goods and services that overshadows the fixed-rate income generated by your investment. Ultimately, this reduces purchasing power.
Lastly, when you open a zero-coupon CD, the money invested and interest accrued are not accessible until maturity. However, the issuing institution periodically applies interest to your account. Generally, as the interest is applied, it is taxable. So, even though you will not receive any of it until maturity, you will be taxed on it throughout the CD term.
Alternatives to Zero-Coupon CDs
CDs are comparable to other high-quality, short-duration instruments, such as U.S. Treasury bills, commercial paper and money market funds — which can be comprised of a variety of cash equivalents, including CDs. CDs are generally less liquid than these alternatives, and fortunately, shrewd investors can command a liquidity premium to account for this.
High-yield savings accounts, which are typically offered by online banks, are another alternative to CDs. These accounts offer very competitive interest rates, and unlike CDs, they do not require you to lock up your money. However, the rates on these accounts can change at any time.
Frequently Asked Questions About Zero-Coupon CDs
To withdraw money from a zero-coupon CD, you must wait until the maturity date. Once the instrument matures, you need to direct the issuing bank or credit union to disburse the funds, either physically or electronically. If you withdraw your money prior to maturity, you will likely face a loss-of-interest penalty.
When you buy a zero-coupon CD, you must keep the amount invested on deposit for a predetermined amount of time. Typically, early withdrawal will result in a loss-of-interest penalty. The penalty usually equates to a certain number of months of interest. However, in some cases, the penalty can result in a loss of principal.
A zero-coupon CD is a prudent investment for someone willing and able to lock up his or her money in exchange for stable interest income. In many circumstances, zero-coupon CDs are purchased alongside a diversified portfolio of longer-term assets, such as stocks, bonds and alternative investments.
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