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 a coupon bond?
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.
What is the profit potential of zero-coupon bonds?
When a company issues bonds, it is effectively borrowing money from investors in exchange for interest payments. Investors are enticed to buy bonds in the first place by interest payments. Zero-coupon bonds, on the other hand, do not pay interest. Rather, investors profit from zero-coupon bonds by purchasing them at a discount to their face value and collecting both the principal and interest payments at maturity. (The difference between the bond’s purchase price and its real face value is represented by the interest at maturity in this scenario.) While a regular bond with a face value of $10,000 might sell for $10,000, a zero-coupon bond with a face value of $10,000 might sell for $5,000 at first.
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.
Why would a corporation issue bonds with no interest?
A zero-coupon bond is a low-cost investment that can be used to save for a specific objective in the future. A zero-coupon bond does not pay interest on a regular basis, but instead sells at a substantial discount and pays the full face value at maturity. Zero-coupon bonds are appropriate for long-term, specific financial needs that can be met in the near future.
How are coupon bonds sold on an annual basis?
The coupon rate is the annual yield on a bond that an investor can anticipate to receive while keeping it. It is computed by dividing the sum of the annual coupon payments by the par value when the bond is issued. A bond’s yield to maturity and coupon rate are the same at the moment of purchase. The yield to maturity (YTM) is the annual percentage rate of return on a bond if the investor maintains the asset until it matures. It is the total of all remaining coupon payments, and it varies according on the market value and the number of payments remaining.
Is there such a thing as a zero-coupon Treasury bond?
T-bills are zero-coupon bonds that are typically sold at a discount, with the difference between the purchase price and the par amount representing your interest.
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.
Do zero-coupon bonds command a higher price?
What circumstances allow a zero-coupon bond to be sold at a premium? A zero-coupon bond, unlike a coupon bond, has no recurring cash flow and only receives one lump-sum payment of the face value at maturity. As a result, a zero-coupon bond will always be sold for less than its face value.