Except for zero-coupon bonds, most bonds pay monthly interest or “coupon” payments. Zeros, as they’re known, are bonds that don’t have a coupon or interest payment.
If interest rates rise,
Instead of receiving interest payments, you purchase a zero bond at a discount to its face value and are paid the face amount when it expires. For example, a 20-year zero-coupon bond with a face value of $10,000 might cost $3,500. The bond’s issuer pays you $10,000 after 20 years. As a result, zero-coupon bonds are frequently acquired to cover a future obligation such as college fees or a projected retirement payment.
Zero-coupon bonds are issued by federal agencies, municipalities, financial institutions, and corporations. STRIPS is the name of one of the most common zeros (Separate Trading of Registered Interest and Principal Securities). An eligible Treasury asset can be converted into a STRIP bond by a financial institution, a government securities broker, or a government securities dealer. The bond gets stripped of its interest, as the name implies.
STRIPS have the advantage of not being callable, which means they cannot be redeemed if interest rates decline. If your bond is called, you receive cash, and you need to reinvest it, this feature protects you from having to settle for a lower rate of return (this is known as reinvestment risk).
However, zero-coupon bonds come with a variety of risks. If you sell before maturity, zero-coupon bonds, like practically all bonds, are susceptible to interest-rate risk. If interest rates rise, the secondary market value of your zero-coupon bond will certainly fall. Long-term zeros can be particularly vulnerable to interest rate movements, putting them at danger of what is known as duration risk. In addition, zeros might not keep up with inflation. While Treasury zeros pose little danger of default, default risk should be considered while researching and investing in corporate and municipal zero-coupon bonds.
Is it possible to purchase zero-coupon bonds?
Bonds with a zero coupon pay no interest for the duration of the bond’s existence. Rather, investors purchase zero coupon bonds at a significant discount to their face value, which is the amount the investor would receive when the bond “matures,” or matures.
Zero coupon bonds typically have long maturities, with many lasting ten, fifteen, or even more years. These long-term maturity dates enable a person to save for a long-term objective, such as paying for a child’s college education. A deep discount allows an investor to put up a small quantity of money that will rise over time.
In the secondary markets, investors can purchase several types of zero coupon bonds issued by a range of issuers, including the US Treasury, companies, and state and local government agencies.
Because zero coupon bonds pay no interest until they mature, their prices fluctuate more in the secondary market than other forms of bonds. Furthermore, even though zero coupon bonds do not require payments until they mature, investors may be subject to federal, state, and local income taxes on the imputed or “phantom” interest that accrues each year. Some investors avoid paying taxes on imputed interest by acquiring municipal zero coupon bonds (assuming they live in the state where the bond was issued) or the rare tax-exempt corporate zero coupon bonds.
What is the procedure for purchasing Treasury zeros?
With your zero coupon bond order, contact your bank or broker. The bond selling price remains the same regardless of who places your order, but keep in mind that the bond purchase price will include a commission. To save money on your commission charge, go with a discount broker rather than a full-service broker.
Who is eligible to issue zero-coupon bonds?
Section 2 (48) of the Income Tax Act now allows only an authorised infrastructure capital firm/fund or a public sector corporation to issue zero-coupon bonds.
How do you decide which bonds to purchase?
Every long-term investment strategy should include bonds. Don’t allow the stock market’s volatility wipe out your life savings. Bonds are a good option if you rely on your investments for income or will in the near future. Make relative value comparisons based on yield when investing in bonds, but make sure you understand how a bond’s maturity and attributes effect its yield. Most importantly, familiarize yourself with key benchmark rates, such as the 10-year Treasury, in order to put each potential investment into context.
What makes a coupon bond different from a zero-coupon bond?
The payment of interest, often known as coupons, distinguishes a normal bond from a zero-coupon bond. A standard bond pays interest to bondholders, whereas a zero-coupon bond does not pay interest to bondholders. Instead, when a zero-coupon bond matures, the holder receives the face value of the bond. Regular bonds, commonly known as coupon bonds, pay interest and repay the principle throughout the course of the bond’s existence.
Can zero-coupon bonds be sold at a higher price?
The time value of money is a notion that shows that money is worth more now than it will be in the future. For example, an investor would prefer to get $100 now rather than $100 in a year. By obtaining $100 today, the investor can put it in a savings account and collect interest, resulting in a total of more than $100 in a year.
Taking the aforementioned concept further, zero-coupon bonds need an investor to be compensated with a higher future value if they purchase the bond today. Because the issuer must provide a return to the investor for purchasing the bond, a zero-coupon bond must trade at a discount.
Why are zero-coupon bonds so dangerous?
Because all interest payments on zero coupon bonds are compounded and paid at maturity, they are more sensitive to interest rate changes than bonds that pay interest semiannually. The higher the volatility, the longer the bond’s maturity.
Do you sell zero-coupon bonds at Fidelity?
Zero-coupon bonds, commonly known as “Strips,” are bonds that pay no interest on a regular basis (i.e., there is no coupon). Instead, you purchase the bond at a discount and receive a single payment when it matures. The payment is equal to the amount you invested plus the interest you’ve earned (compounded annually to maturity).
A US savings bond, which is a “non-marketable” Treasury instrument that can be purchased directly from the Treasury or from most institutions, is perhaps the most well-known example of a zero-coupon bond. (Fidelity also sells additional zero-coupon Treasury securities that can be bought and sold on the secondary market.) There’s a reason why many parents and grandparents consider these ties to be a favorite present: When you want to save for a certain goal and date, such as when your child attends college, zero-coupon bonds are appealing. At maturity, you will get your principle and interest in one lump sum.
Assume you’re putting money aside for your child’s college education, which will start in ten years. You could buy a $16,000 10-year zero-coupon bond with a face value of $20,000 for $16,000. At the end of ten years, you will receive the face value of $20,000.
There are a few disadvantages to zero-coupon bonds. First, even if you do not collect the interest until maturity, you will almost always have to pay taxes on it annually. If you acquire the bonds in a tax-deferred retirement account or in a custodial account for a kid in a circumstance where the youngster pays little or no tax, this can be offset.
In the open market, zero-coupon bonds can be extremely volatile, making them particularly vulnerable to interest rate risk. It makes no difference if you hold the bond until it matures. However, if you need to sell it quickly, you could lose a lot of money.
How can you figure out how much a coupon bond is worth?
The coupon rate is derived by multiplying the total amount of annual payments made by the bond’s face value (or “par value”) by the entire amount of annual payments made by the bond.
For instance, ABC Corporation issues a $1,000 bond at issue. It pays the holder $50 every six months. To find the bond coupon rate, multiply the total annual payments by the par value of the bond:
The coupon rate on the bond is 10%. This is the percentage of the company’s value that it returns to investors each year.