Zero-coupon bonds are usually long-term investments ; they often mature in ten or more years. Although the lack of current income provided by zero-coupons bond discourages some investors, others find the securities ideal for meeting long-range financial goals like college tuition. The deep discount helps the investor grow a small amount of money into a sizeable sum over several years. Because zero-coupon bonds essentially lock the investor into a guaranteed reinvestment rate , purchasing zero-coupon bonds can be most advantageous when interest rates are high.
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They are also more advantageous when placed in retirement accounts where they remain tax-sheltered. Some investors also avoid paying taxes on imputed interest by buying municipal zero-coupon bonds, which are usually tax-exempt if the investor lives in the state where the bond was issued. The lack of coupon payments on zero-coupon bonds means their worth is based solely on their current price compared to their face value.
Thus, prices tend to rise faster than the prices of traditional bonds when interest rates are falling, and vice versa.
What Is a Zero-Coupon Bond? - TheStreet Definition
The locked-in reinvestment rate also makes them more attractive when interest rates fall. Show 5 More. Our in-depth tools give millions of people across the globe highly detailed and thoroughly explained answers to their most important financial questions. Each month, more than 1 million visitors in countries across the globe turn to InvestingAnswers.
What is the difference between a zero-coupon bond and a regular bond?
Financial Dictionary Calculators Articles. Zero-Coupon Bond. What it is:. How it works Example :. Why it Matters:. Popular Now.
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What is a Small-Cap Stock? A bond is a portal through which a corporate or governmental body can raise capital. When a bond is issued, investors purchase the bonds, and in effect, act as lenders to the issuing entity.
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The investors earn a return in the form of coupon payments made annually or semi-annually throughout the life of the bond. When the bond matures , the bondholder is repaid an amount equal to the face value of the bond.
If a corporate bond is issued at a discount , this means investors can purchase the bond below its par value. But not all bonds have coupon payments. Such bonds are referred to as zero coupon bonds. These bonds are issued at a deep discount and repaid the par value at maturity. The difference between the purchase price and the par value represents the investor's return.
The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. The interest earned on a zero-coupon bond is an imputed interest , meaning that it is an estimated interest rate for the bond, not an established interest rate.
So, although no coupon payments are made on zero coupon bonds until maturity, investors may still have to pay federal, state, and local income taxes on the imputed or phantom interest that accrues each year. Purchasing a municipal zero coupon bond, buying zero coupon bonds in a tax-exempt account, or purchasing a corporate zero coupon bond that has tax-exempt status are a couple of ways to avoid paying income taxes on these securities. The greater the length of time until the bond matures, the less the investor pays for it, and vice versa.
The maturity dates on zero coupon bonds are usually long term, with many having initial maturities of at least 10 years. With the bond's deep discount, an investor can put up a small amount of money that can grow over many years. Investors can choose zero coupon bonds that are issued from a variety of sources, including the U. Most zero coupon bonds trade on the major exchanges.
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