Generally, zero coupon bonds compound interest based upon 6 month compounding periods. They differ from regular coupon bonds, which pay simple interest or, interest only on principal, in that they compound interest or, credit interest on interest and principal. Therefore, we refer to the current value of a zero coupon bond as the current accreted value. Because of the compound nature of the interest accreted, the actual amount of interest earned in the first years of a zero coupon bond will be nominal when compared to the actual amount of interest earned in years just prior to maturity. Zero coupon bonds give certain huge advantages over regular bonds.
Compound interest makes a huge difference in the actual cash return of a fixed income investment.
As you can see, in this example the zero-coupon bond investor has doubled the actual cash interest received versus the current coupon investor over the same time period and at the same interest rate. The reason this works is because of compounding, or reinvestment of principal and interest. The basic premise outlined here is that investments that compound interest will always return more actual dollar results than simple interest investments given parity in time, quality and interest rate. As with any fixed income instrument, market prices rise for bonds when interest rates drop and bond prices dip when interest rates rise. We call this market rate risk.