A zero-coupon bond is a type of bond that earns no interest during its lifetime. A zero-coupon bond is issued with a sudden reduction in par value or face value, which is the amount that will be paid for the bond at maturity. An investor receives a one-time interest payment at maturity equal to the difference between the face value and the discounted initial purchase price. The difference between the face value and the original discounted purchase price is known as the original issue discount.
What is a zero-coupon bond?
A zero-coupon bond is a type of fixed income instrument that pays no interest on the principal until maturity. Municipalities and businesses often issue Zero-coupon bonds to make saving for retirement, education, or other purposes more affordable. Unlike traditional bonds, which provide for periodic (usually semi-annual) interest payments over the useful life, no periodic interest payments will be made for a zero-coupon bond before maturity. In this case, the return on an investor consists of two parts: the appreciation of higher market prices at the time of redemption and any initial accumulated original issue discount that may have accumulated over the lifetime of the investment.
What are the types of zero-coupon bonds?
Zero coupons with redemption clauses can also be issued if market rates fall below certain levels; this will allow issuers to redeem (recover) these bonds at face value before the maturity date. This ensures investor confidence at times when rates can rise significantly.
Who uses zero-coupon bonds?
Zero-coupon bonds are used more by companies that need financing due to their long-term nature (compared to other types, such as short-term certificates of deposit). The investor can then be reimbursed at a low or fixed rate and at an amount greater than that initially invested at the agreed time.
Companies often issue these types of bonds because they do not want the necessary interest paid after issuance, as their funds can go elsewhere; it also leaves the investor at risk. This type of bond is also used by governments who need to raise funds to help their country in a financial crisis but do not want to pay interest after issuance because they could spend that money elsewhere. The government does not encounter such risk when issuing these bonds, as they can force repayment, if necessary, and have to pay, even if they do not profit from it.
The last type of zero-coupon bonds are those issued for investment purposes in companies or funds; this gives investors the ability to earn higher rates of return without paying an upfront fee (because people buy in different periods). This makes sense, given the general nature of the lower risk observed for shorter-term investments.
What are the advantages of zero-coupon bonds?
Zero-coupon bonds are usually issued with a sudden reduction in their face value, which means that the investor can make large profits by holding them to maturity. The discount rate is intended to compensate for the time that investors have to wait before receiving interest payments. Zero-coupon bond funds are an easy way for investors looking for market performance but not volatility or taxes on short-term investments (such as capital gains and dividends) who also want these bonds.
What are the disadvantages of zero-coupon bonds?
The downside of zero-coupon bonds is that they may not offer the investor as many benefits, such as a higher return on investment and tax benefits. These types of bonds also have a higher risk because there is no income over their useful life. The price an investor pays for these bonds is predetermined by face value, so it can be difficult to know whether you will win or lose money until all payments have been made.
What are the alternatives to zero-coupon bonds?
Alternatives to zero-coupon bonds are ordinary bonds, discount treasury bills, or other types of fixed-income investments, such as certificates of deposit (CDs) and government bonds.
How to buy zero-coupon bonds?
Zero-coupon bonds are generally not available for purchase as they usually require a large investment. They can be bought through a negotiated fund (ETF) or a mutual fund specializing in zero-coupon bonds. Zero-coupon bond funds offer investors diversification and lower transaction costs than buying individual bonds.
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