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Usually a part of the funds will be accumulated interest at maturity along with the original amount that was paid to purchase the bond. The investor is paid a lump sum amount which nothing but the initial investment along with the interest that has accrued during the term of maturity.
Although zero coupon bonds do not pay interest until maturity, the interest amount is not usually tax deferred. You will have a tax liability on a yearly basis that you will have to pay because of the assumed yield. This tax is known as phantom tax. However, you can avoid income tax by investing in zero coupon bonds issued by municipalities. Sometimes, corporations issue special zero coupon bonds that are tax exempt and you do not have to pay taxes annually.
You can purchase a zero coupon bond from the secondary market or you can purchase them directly from the issuing sources like the US Treasury, corporations, and state and local government entities. Most investors are attracted to zero coupon bonds because they can lock in the interest rate at the time of purchase for the entire term of the bond. This means that investors will get a fixed amount of time at end of the term of the bond.
Let us assume that you purchase a zero coupon bond for $341 which matures in 2027 at a face value of $1,000. This means that the annual return is 5.4 percent. However, inflation is has been averaging 3 percent over the last 20 years so you will see that a lot of your returns have disappeared on account of inflation. The amount that you get from a zero coupon bond may not have the buying power when they mature and this is something many investors need to take into account.
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