Zero Coupon Bonds
Zero coupon bonds are bonds sold at a discount, and when they mature, the owner receives the full face value of the bond. Unlike most other types of bonds, zero coupon bonds do not make periodic interest payments. This type of bond is issued by the U.S. Treasury, federal agencies, municipalities, corporations and stock brokerage houses themselves.
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Example
Tim buys a zero coupon bond with a face value of $2,000. He pays $500 for the bond. When the time period of the bond is up (it matures), Tim receives $2,000, the full face value of the bond.
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The issuer of zero coupon bonds can require you to turn in your bonds before the maturity date. If that happens, you won't get the full face value of the bond. Instead your payment is calculated based on a graduated scale.
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Did You Know?
Zero coupon bonds kept the name they were given years ago when bonds were issued with coupons attached. Bondholders tore or cut off a coupon and turned it in, in return for their interest payment. The coupons are no longer used, but the name stuck.
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Investing in zero coupon bonds has the primary advantage of locking in a good interest rate. But the locking in feature of zero coupon bonds can also be its downfall. How so? If you invest in a zero coupon bond, you lock in an interest rate for a specified period of time. That's great if the interest rates go down during that time period because you'll be locked in at a higher rate. However, if the interest rates go up during the time period of the bonds, not only is the principal amount you paid for the bonds locked in at a lower rate, but you aren't getting periodic interest payments so you can't even reinvest your interest into another investment vehicle with a higher interest rate.
Another downside to investing in zero coupon bonds is that generally, even though you don't actually receive any periodic interest payments, the IRS taxes you on the payments you're earning. So not only do you not have use of your interest earned, but you're taxed on it as well. The interest earned from municipal zero coupon bonds may not be subject to federal tax and may be exempt from state and local taxes as well. Interest earned from treasury-issued zero coupon bonds is also generally exempt from state and local taxation.
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