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 would someone want to put money into a zero-coupon bond?
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 a zero coupon bond, and how does it benefit investors?
The payment of interest, or coupons, distinguishes a zero-coupon bond from a standard bond. Regular bonds, commonly known as coupon bonds, pay interest and repay the principle throughout the course of the bond’s existence. A zero-coupon bond does not pay interest and instead trades at a steep discount, resulting in a profit when the bond is redeemed for its full face value at maturity.
How do bond investors profit from them?
- The first option is to keep the bonds until they reach maturity and earn interest payments. Interest on bonds is typically paid twice a year.
- The second strategy to earn from bonds is to sell them for a higher price than you paid for them.
You can pocket the $1,000 difference if you buy $10,000 worth of bonds at face value meaning you paid $10,000 and then sell them for $11,000 when their market value rises.
There are two basic reasons why bond prices can rise. When a borrower’s credit risk profile improves, the bond’s price normally rises since the borrower is more likely to be able to repay the bond at maturity. In addition, if interest rates on freshly issued bonds fall, the value of an existing bond with a higher rate rises.
Does a bond with a zero coupon pay interest?
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.
For an issuer, what is the primary benefit of zero-coupon bonds?
The predictability of zero-coupon bonds is another significant benefit. If you hold these bonds until they mature, you’ll get the whole face value back. You’ll also have scored a bargain: you’ll be paying less now for more later.
As a result, these bonds are a suitable choice for investors who want to achieve a certain financial goal over a long period of time.
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.
Is bond investing a wise idea in 2021?
Because the Federal Reserve reduced interest rates in reaction to the 2020 economic crisis and the following recession, bond interest rates were extremely low in 2021. If investors expect interest rates will climb in the next several years, they may choose to invest in bonds with short maturities.
A two-year Treasury bill, for example, pays a set interest rate and returns the principle invested in two years. If interest rates rise in 2023, the investor could reinvest the principle in a higher-rate bond at that time. If the same investor bought a 10-year Treasury note in 2021 and interest rates rose in the following years, the investor would miss out on the higher interest rates since they would be trapped with the lower-rate Treasury note. Investors can always sell a Treasury bond before it matures; however, there may be a gain or loss, meaning you may not receive your entire initial investment back.
Also, think about your risk tolerance. Investors frequently purchase Treasury bonds, notes, and shorter-term Treasury bills for their safety. If you believe that the broader markets are too hazardous and that your goal is to safeguard your wealth, despite the current low interest rates, you can choose a Treasury security. Treasury yields have been declining for several months, as shown in the graph below.
Bond investments, despite their low returns, can provide stability in the face of a turbulent equity portfolio. Whether or not you should buy a Treasury security is primarily determined by your risk appetite, time horizon, and financial objectives. When deciding whether to buy a bond or other investments, please seek the advice of a financial counselor or financial planner.
In Kenya, how can treasury bonds create money?
Treasury notes are sold at a discount, which allows investors to profit. If you invest in a 91-day Treasury bill, for example, you will pay less than the bill’s face value at first, but you will receive the entire face value after 91 days. A minimum investment of Kshs. 100,000 is required to purchase a Treasury bill.
How does a zero or very low coupon bond provide a return to an investor?
For taking on more risk, investors will demand a bigger return. How does an investor profit from a bond with a zero or very low coupon rate? Bonds save you money on taxes.