Zero-coupon Bonds
Article Provided by FinancialContent
By Chris Stallman
| E-mail
When you
think of bonds, what is the first thing that comes to mind? The
first thing that comes to my mind is the interest that they pay.
However, not all bonds pay interest.
One common
term among bond investors is a "coupon". It refers to
interest paid on bonds. Therefore, "zero coupon" means
"no interest". Zero coupon bonds don't pay interest
to the investor while they are maturing. The interest accrues and
the value of the bond increases. The investor can then sell it for
the face value once it matures..
Zero coupon bonds are issued by municipalities, the
federal government, and corporations. Like with all bonds, they
issue these so that investors can loan them money for immediate
use and the investors are then later repaid. The amount loaned
is called the "principal."
When figuring
the yield of the bond, you divide the par value and the purchasing
price. You then account for the time until maturity. This will allow
you to have an idea of what your annual return would be.
Advantages
Zero coupon
bonds have some really attractive features to them. One is that
you buy zero coupon bonds at a deep discount. This means that you
pay much less than the bond's par value, the amount it is worth
at maturity. As the bond matures, the interest is accrued and the
bond increases in value. Because the interest isn't paid out
yearly, the bonds can be issued at a deep discount
Zero coupon bonds also offer investors predictability
for the long-term. Zero coupons are volatile investments but they
still provide a predictable return for investors who want a lump
sum of money paid by a specific date.
One last advantage of zero coupon bonds is that they
also benefit whoever issues them. Because they don't pay periodic
interest, they allow corporations, municipalities, and the government
to continue using the loan amount without having to pay back interest.
Disadvantages
Zero coupon
bonds also have a few drawbacks. The first big drawback is that
they are extremely volatile investments. Interest rates changes
can swing the price of the bond in either direction. This means
that if you want to sell it before it matures, you aren't guaranteed
to make a profit. However, if you hold it until maturity, you won't
have to worry about this. As with stocks, long-term investing in
zero coupon bonds is the best way to go.
Another major drawbacks is that you still have to pay
income taxes on the bonds while they are maturing. With regular
interest-yielding bonds, you would have to pay income taxes on the
amount of interest you earned. Well, with zero coupon bonds, you
have to pay taxes each year on the amount of interest you would
have earned. One way to get
around this is to invest in tax-free zeros, such as municipal zeroes.
Or you can find a qualified tax-deferred retirement plan and put
the zero coupon bonds in there.
One final drawback to investing in zeroes is that they
are callable. What this means is that the issuer can say that they
want to repay the bonds before maturity at a certain percentage
rate. This really makes your taxes complicated because if the IRS
thinks you made more than you should have, you would have to pay
a capital gains tax as well.
Zero coupon bonds offer investors one more way to invest
in bonds and they do have advantages. For those who understand them,
they provide an excellent way of investing for the long-term. Just
because they are bonds, that doesn't mean they don't carry
their own risks. We encourage you to weigh the risks and rewards
before investing.
Previous
Article - Next Article
Like
this article? Bookmark
It
