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They pay no 'coupon' which is the income paid periodically. You make a return by buying at a discount.
As an example, if you buy a zero coupon bond for $86.26, maturing at $100 over 5 years, you would earn 3% p.a.
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How do bondholders get a return on zero coupon bonds?
Zero coupon bonds do not pay interest and are therefore sold at a steep discount to face value depending on the maturity date of the bond. Due to the time value of money, the discount on a 30 year zero coupon bond will be much greater than on a 10 year zero coupon bond. At maturity bondholders will receive the full face value of the bond which provides bondholders a return. For example, a 30 year zero coupon bond with a face value of $1,000 and sold for $500 would return a $500 profit after 30 years. Holders of zero coupon bonds can sell the bonds at any time before maturity. If an investor bought zero coupon bonds prior to a steep drop in interest rates, the value of the zero coupon bonds would increase and could be sold at a profit.
Which type of investor would be most likely to purchase zero coupon bonds?
(4) risk-averse investors anticipating increases in interest rates
Zero Coupon Bonds?
When you buy a standard bond you invest in an instrument that pays interest. The rate of interest paid is also known as the coupon rate, or just coupon for short. If you invest $10,000 in bonds priced at par, or 100, with a coupon of 3%, you know you'll receive 3% annually and get your principal back at par upon maturity. So if you are an astute reader and you noticed the title of this post you know it has something to do with zero coupon bonds. According to what we know about how bonds work why would anybody put their money into a bond that doesn't' pay interest? It's true that zeroes don't pay out in regular interest payments like bonds that pay a coupon. But that doesn't mean you don't get compensated for your investment. The way a zero coupon bond works is that you buy it at an initial discount to par and upon maturity you receive par. As an example, let's assume you wanted to buy $10,000 worth of zero coupon bonds. Instead of receiving a price of par, or 100, you're given a discounted price of, say, 85. This means that if you invest $8,500 now, upon maturity you'll receive the full $10,000. The difference between what you paid and the maturity amount becomes your interest income. The bonds are assumed they are earning interest each year even though they don't pay you any actual money. In bondspeak this is referred to as the bond's accretion. One catch here is that the IRS still charges you income tax on that theoretical income. It calls it imputed income. One way to legally sidestep having to pay income tax on accreted income is to invest in zeroes within your IRA, 401(k), or other tax sheltered investment account. One of the benefits (or drawbacks) to zero coupon bonds is that you don't have actual money coming to you that you must reinvest at current rates. This can work to your advantage if you bought your zero before rates fell because instead of having to reinvest your income at new lower rates you're locked in. However, the opposite is true if rates rise and that can be a major drawback to zeroes. Since they return absolutely nothing to you until maturity they are much more sensitive to interest rate fluctuations than standard bonds. The longer maturity on the zero the greater this amplified effect can be. On a long maturity zero coupon bond you are locking in a rate of interest not only for your principal but also on the imputed income for a long period of time. You don't have the option to invest the income spun off the bond at different rates so you are much more affected by interest rate changes than an investor in regular bonds for the total length of time to maturity.
What is the advantage of buying zero-coupon bonds?
The advantage of buying zero-coupon bonds is that when they reach maturity, the investor then receives the full face value of the bond. These bonds became popular in the 1980's even though they were first released in the 1960's.
How are Savings bonds different from other bonds?
There are two kinds of bonds: coupon and zero-coupon bonds. A coupon bond pays interest on a periodic schedule--and what the schedule is depends on the bond. When you get the bond, it's got a certain number of coupons attached to it. Each one is dated and says how much interest you will receive when you redeem it. The main part of the bond is the corpus--the "body"--and when redeemed, you will receive the money you spent to buy the bond back. If you buy an investment-grade coupon bond, and its face value is $1,000, you need $1,000 to buy the bond. Note I said "investment-grade" here. If you buy a coupon bond that's in the junk category, quite often they sell at a discount from face value. But junk bonds are a world of their own. Savings bonds are zero-coupon bonds. They sell at a discount from face value--right now it's 50 percent, so if you want a $100 savings bond you need to bring $50. When the bond matures and is redeemed, you will receive the face value of the bond. There are no periodic interest payments with these bonds.
How do bondholders get a return on zero coupon bonds?
Zero coupon bonds do not pay interest and are therefore sold at a steep discount to face value depending on the maturity date of the bond. Due to the time value of money, the discount on a 30 year zero coupon bond will be much greater than on a 10 year zero coupon bond. At maturity bondholders will receive the full face value of the bond which provides bondholders a return. For example, a 30 year zero coupon bond with a face value of $1,000 and sold for $500 would return a $500 profit after 30 years. Holders of zero coupon bonds can sell the bonds at any time before maturity. If an investor bought zero coupon bonds prior to a steep drop in interest rates, the value of the zero coupon bonds would increase and could be sold at a profit.
Which type of investor would be most likely to purchase zero coupon bonds?
(4) risk-averse investors anticipating increases in interest rates
What is the taxation of zero coupon bonds held to maturity?
Zero coupon bonds issued by the US Treasury are issued at a discount to face value. An investor holding zero coupon bonds is paid the full face value when the zero coupon bond matures. The difference between the purchase price and the maturity value is know as the original issue discount which represents the interest earned on the zero coupon bond. Although a zero coupon bond does not pay annual interest, an investor must pay taxes each year based on the imputed receipt of income. Since the investor is not receiving interest payments during the life of the bond, taxes would be paid on interest income not actually received until bond maturity. Due to the yearly tax liability on imputed interest, it makes sense for most investors to hold zero coupon bonds in a tax deferred retirement account. The interest earned on zero coupon bonds issued by the US Treasury are exempt from state and local taxes.
What is so special about Zero Coupon Municipal Bonds?
Zero Coupon Municipal Bonds are special because, unlike other bonds, they have no periodic interest payments. Rather, the investor receives one payment at maturity. This payment is equal to the amount invested, plus the interest earned, compounded semiannually.
What kinds of penalties are attached to zero coupon bonds if withdrawls are made early?
Many zero-coupon bonds (e.g. US Treasuries) penalize for early redemption through forfeiture of interest for a specified period of time.
What is a zero coupon?
A zero coupon is, in a financial sense, a security which does not pay interest periodically.
Zero Coupon Bonds?
When you buy a standard bond you invest in an instrument that pays interest. The rate of interest paid is also known as the coupon rate, or just coupon for short. If you invest $10,000 in bonds priced at par, or 100, with a coupon of 3%, you know you'll receive 3% annually and get your principal back at par upon maturity. So if you are an astute reader and you noticed the title of this post you know it has something to do with zero coupon bonds. According to what we know about how bonds work why would anybody put their money into a bond that doesn't' pay interest? It's true that zeroes don't pay out in regular interest payments like bonds that pay a coupon. But that doesn't mean you don't get compensated for your investment. The way a zero coupon bond works is that you buy it at an initial discount to par and upon maturity you receive par. As an example, let's assume you wanted to buy $10,000 worth of zero coupon bonds. Instead of receiving a price of par, or 100, you're given a discounted price of, say, 85. This means that if you invest $8,500 now, upon maturity you'll receive the full $10,000. The difference between what you paid and the maturity amount becomes your interest income. The bonds are assumed they are earning interest each year even though they don't pay you any actual money. In bondspeak this is referred to as the bond's accretion. One catch here is that the IRS still charges you income tax on that theoretical income. It calls it imputed income. One way to legally sidestep having to pay income tax on accreted income is to invest in zeroes within your IRA, 401(k), or other tax sheltered investment account. One of the benefits (or drawbacks) to zero coupon bonds is that you don't have actual money coming to you that you must reinvest at current rates. This can work to your advantage if you bought your zero before rates fell because instead of having to reinvest your income at new lower rates you're locked in. However, the opposite is true if rates rise and that can be a major drawback to zeroes. Since they return absolutely nothing to you until maturity they are much more sensitive to interest rate fluctuations than standard bonds. The longer maturity on the zero the greater this amplified effect can be. On a long maturity zero coupon bond you are locking in a rate of interest not only for your principal but also on the imputed income for a long period of time. You don't have the option to invest the income spun off the bond at different rates so you are much more affected by interest rate changes than an investor in regular bonds for the total length of time to maturity.
Assume that all interest rates in the economy decline from 10 percent to 9 percent what bonds will have the largest percentage increase in price?
A 10-year zero coupon bond.Source: http://www.transtutors.com/homework-help/corporate-finance/bond-valuation/
What is a zero-coupon note?
A zero-coupon note is a note which pays at maturity the value of the note with no separate interest payments.
What is the advantage of buying zero-coupon bonds?
The advantage of buying zero-coupon bonds is that when they reach maturity, the investor then receives the full face value of the bond. These bonds became popular in the 1980's even though they were first released in the 1960's.
How are Savings bonds different from other bonds?
There are two kinds of bonds: coupon and zero-coupon bonds. A coupon bond pays interest on a periodic schedule--and what the schedule is depends on the bond. When you get the bond, it's got a certain number of coupons attached to it. Each one is dated and says how much interest you will receive when you redeem it. The main part of the bond is the corpus--the "body"--and when redeemed, you will receive the money you spent to buy the bond back. If you buy an investment-grade coupon bond, and its face value is $1,000, you need $1,000 to buy the bond. Note I said "investment-grade" here. If you buy a coupon bond that's in the junk category, quite often they sell at a discount from face value. But junk bonds are a world of their own. Savings bonds are zero-coupon bonds. They sell at a discount from face value--right now it's 50 percent, so if you want a $100 savings bond you need to bring $50. When the bond matures and is redeemed, you will receive the face value of the bond. There are no periodic interest payments with these bonds.
Is zero coupon bond more sensitive to change in interest rate than fixed coupon bond?
The zero coupon bond is more sensitive to change in rate (inflation) because the market value is not based on a fixed coupon.
