Zero Coupon Bonds – What They Are And How They Work

learnbonds-glossaryA zero-coupon bond (also known as a pure discount bond) does not make periodic interest payments, or coupons, to the bondholder, but is issued at a deep discount to face value. When the bond reaches maturity, the investor receives its face value. The yield is the difference in the price at which the bond was issued and the maturity value.

Zero Coupon Bond Example

Suppose company X has issued 10,000 $100 face value bonds with a term of 10 years. Since the company does not want to make any periodic interest payments, it has priced the bond at $62 per bond. In 10 years the company will pay back $100, and an investor would earn $100 – $62 = $38 as the compensation. Zero-coupon bonds may be issued by federal or state governments. Municipalities and corporations also issue such bonds. Since corporate zero-coupon bonds carry the most risk of default, they pay the highest yields. Zero-coupon bonds can also be created by investment banks and brokerage firms, who take a regular bond and separate the principal from the interest payments to create two separate securities. This process, referred to as “stripping,” results in a zero-coupon bond that can be sold to investors. The future interest payments is also packaged and sold to investors who need a steady cash flow.

Zero coupon bonds can either be long or short term investments. The greater the time until a bond’s maturity, the less the investor pays for the bond. Long-term zero coupon maturity dates generally start at 10 to 15 years. The bond can be held until maturity or sold on the secondary bond markets. Short-term zero coupon bonds typically have maturities of less than a year and are called bills. Since zero-coupon bonds usually have long maturity dates, it is important to ascertain the credit worthiness of the issuer. If the issuer were to become insolvent, the investor would lose all profit on the bond. Also, because zero coupon bonds pay no interest until maturity, their prices tend to fluctuate more in the secondary market compared to regular bonds. In the United States, the holder of a zero-coupon bond owes income tax on the imputed or “phantom” interest that has accrued each year, even though these bonds don’t pay periodic interest. Some investors avoid paying taxes on imputed interest by placing zero coupon bonds subject to U.S. taxation in tax-deferred retirement accounts. Municipal zero-coupon bonds are also usually tax-exempt if the investor lives in the state where the bond was issued.

When to Invest In Zero Coupon Bonds

Zero-coupon bonds are useful to investors who need a specific amount of money on a specific date in the future. The long maturity dates allows an investor to plan for a long-term goal, such as the future college funding needs of a young child. With the deep discount at offer, an investor can invest a small amount of money that can grow over the many years till maturity. Zero-bonds are also an appealing option for investors with little appetite for the whipsaws of the financial markets. An investor can simply buy the bond and wait for it to mature, without worrying for other external factors that may erode the value of their investment. Pension funds and insurance companies also like to own long maturity zero-coupon bonds because of their high duration. The high duration ensures that the bonds’ prices are particularly sensitive to changes in the interest rate, which immunize these firms against the interest rate risk of their long-term liabilities.

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David Waring

David Waring was the founder of LearnBonds.com and has been a major contributor to the extensive library of investing news and information available on the site. Until the launch of Learnbonds.com in late 2011 there was no single site on the internet catering exclusively to the individual bond investor. This was true even though more individuals own stocks than bonds. Learn Bonds was launched to fill that gap.

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