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A zero coupon bond is a bond that is issued at a discount from its par value and makes no regular interest payments. An investor’s interest is reflected by the security’s appreciation towards par at maturity. The appreciation is taxable each year even though it is not actually received by the investor and is known as phantom income.
An investor wishing to have a set amount of money at a certain date may purchase zero coupon bonds to reach this objective. If an investor wanted to have $20,000 in 10 years to help pay for their child’s education, the investor could purchases zero coupon bonds that mature when their child starts college in 10 years. The bonds would be purchased at a discount from par ($1,000) and would mature at par at which time the investor would receive $1,000 per bond. Interest rates at the time of purchase, the time until maturity and the issuer of the bonds will all factor into the price paid for the bonds.