Zero-coupon municipal bonds are bonds that do not provide periodic interest payments. Most other municipal bonds will provide interest payments on a semiannual basis. Zero-coupon bonds, however, pay nothing on the investment until maturity.
Municipal bonds are an investment option that allows the investor to invest in a city, state or federal government. The investor purchases a bond that reaches maturity at a specific time many years in the future. During the maturity period, the government might use the money for projects such as building schools or repaving roadways, or it might use the funds for operating expenses. Municipal bonds typically take 10 years or more to mature.
Municipal bonds are often attractive to investors for a number of reasons. First, by purchasing municipal bonds from a local government, the investor might see the impact of the improvements resulting from the investment if he or she lives in the community where the bond was purchased. Second, municipal bonds frequently require a small up-front investment. For instance, a bond that has a face value of $10,000 US Dollars (USD) at maturity might be bought for only $3,000-$4,000 USD. Of course, the interest rate at the time of purchase will affect the price.
Third, municipal bonds are generally a low-risk investment. Although the interest on the return might not be as high as on other investments, the risk is also lower because a government rarely defaults on its debts. Finally, interest income generated from a municipal bond is often not taxed.
Zero-coupon municipal bonds differ from other municipal bonds in the way that interest is paid to the investor. With most municipal bonds, the interest is calculated on a semiannual or annual basis and paid out to the investor, whereas a zero-coupon municipal bond holder receives nothing on the investment until the bond reaches maturity.
The amount of interest the investors will receive on zero-coupon municipal bonds is always known in advance. What separates basic municipal bonds from zero-coupon municipal bonds is when the interest is paid. The holder of a $10,000 USD bond who paid $3,000 USD for the bond will always receive $7,000 USD in interest. If the bond is a basic municipal bond, that interest will be paid out in semi-annual or annual payments over the life of the bond, but if the bond is a zero-coupon municipal bond, he or she will receive all of that interest upon maturity.