Zero Coupon Bonds
Zero coupon bonds or “zeros” put a unique twist on the traditional bond. Zeros are bonds issued by corporations and Federal (Treasury bonds), state or local governments (municipal bonds) and pay no periodic interest payments. In other words, an investor receives one payment--at maturity. The maturity value an investor receives is equal to the principal invested plus interest earned, compounded semiannually, at the original interest rate to maturity.
Zeros are issued by major corporations, municipalities, and the U.S. Government.
Because of this payment structure, zero coupon bonds are sold at a substantial discount from the face amount. Therefore, you can purchase more zero coupon bonds for your money than other types of bonds precisely because they are sold at a substantial discount from face amount. Due to the time-value of money, the longer the maturity of a zero coupon bond, the less you have to pay for it. Zeros allow investors to put aside a modest amount of money today and know exactly how much money they will receive on a specified future date.
The zero coupon bond structure provides another benefit to investors. Because zero coupon bonds pay one payment at maturity, equal to the principal invested plus interest earned, investors are able to lock in a particular rate of return. This eliminates reinvestment risk or the worry about what interest rates may do in the future. In a traditional bond, when you receive an interest payment, you will have to reinvest that interest payment in a security that is equal to the quoted yield to maturity you expected when you purchased the bond. Depending on future prevailing interest rates, your reinvestment may yield interest payments that are lower or perhaps higher than the bond coupon. With an investment in a zero coupon bond you don’t have to worry about the return. But you also must realize that you will not receive the periodic income.
Zero-coupon bonds tend to fluctuate in price much more than a coupon bond, because they offer the entire payment at maturity. Therefore, zero coupon bonds are a good alternative if you have a specific investment time frame and you are quite certain that you can hold the bonds until maturity. For example, you may invest in a zero today to pay for a child's college tuition payments. However, because of their volatility, they may not be suitable if you need immediate access to cash. Unless you hold them in a tax-deferred account, the interest that accrues on these bonds may be subject to income taxes annually, even though you don't receive any interest payments until maturity. To avoid the tax burden, consider an investment in municipal zero coupon bonds that generate tax-free income that is payable at maturity (learn more at zero coupon municipals). You should always consult your tax advisor about the special tax consequences of zero coupon bonds.
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