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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 else can I help you with?
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.
What are the companies offering zero coupon bonds?
Zero coupon bonds are typically issued by governments, municipalities, and corporations. Prominent companies that offer zero coupon bonds include major corporations like Disney and Coca-Cola, which have issued them in the past. Additionally, U.S. Treasury securities, such as Treasury bills, can function as zero coupon bonds. Investment firms and mutual funds may also provide access to zero coupon bond investments through specific funds or portfolios.
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.
What are the interest rates for zero coupon bonds?
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.
How are investors in zero coupon bonds compensated for making such an investment?
They are sold at discount and mature to face value over time.
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.
What are the companies offering zero coupon bonds?
Zero coupon bonds are typically issued by governments, municipalities, and corporations. Prominent companies that offer zero coupon bonds include major corporations like Disney and Coca-Cola, which have issued them in the past. Additionally, U.S. Treasury securities, such as Treasury bills, can function as zero coupon bonds. Investment firms and mutual funds may also provide access to zero coupon bond investments through specific funds or portfolios.
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.
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 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.
Why do people like zero coupon bonds?
Zero coupon bonds are sold at a price well below face value. Thus, these bonds are appealing to the small investor because they can be bought far more cheaply than ordinary debt obligations. The discount is usually from 50 to 75 percent.
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 are the interest rates for zero coupon bonds?
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.
How are investors in zero coupon bonds compensated for making such an investment?
They are sold at discount and mature to face value over time.
What are the types of bonds in financial management?
In financial management, the primary types of bonds include corporate bonds, government bonds, municipal bonds, and zero-coupon bonds. Corporate bonds are issued by companies to raise capital, while government bonds are issued by national governments and are considered low-risk. Municipal bonds are issued by states or local governments to fund public projects, and zero-coupon bonds are sold at a discount and do not pay interest until maturity. Each type has distinct risk profiles, tax implications, and investment characteristics.
Can you compute the price of a 5-year zero coupon bond from 2 5 year coupon bonds?
If the 2 5 years are exactly the same with the exception of having coupons (same lender, same claims, same everything) then yes you should be able to. The trick is finding the right yield curve and discounting everything back to the present value. The coupons can be treated as mini zero-coupon bonds in their own right.
What is a zero coupon?
A zero coupon is, in a financial sense, a security which does not pay interest periodically.
