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The deep discount helps the investor grow a small amount of money into a sizeable sum over several years. Because zero-coupon bonds essentially lock the investor into a guaranteed reinvestment rate , purchasing zero-coupon bonds can be most advantageous when interest rates are high.
They are also more advantageous when placed in retirement accounts where they remain tax-sheltered. Some investors also avoid paying taxes on imputed interest by buying municipal zero-coupon bonds, which are usually tax-exempt if the investor lives in the state where the bond was issued. The lack of coupon payments on zero-coupon bonds means their worth is based solely on their current price compared to their face value.
Thus, prices tend to rise faster than the prices of traditional bonds when interest rates are falling, and vice versa. The locked-in reinvestment rate also makes them more attractive when interest rates fall.
To find the zero coupon bond's value at its original price, the yield would be the value may fluctuate as the current interest rates of the market may change. You can use the bond price formula to determine the value of a bond. compares to the average rate most investors are currently receiving in the bond market. It's important to note that zero-coupon bonds are always priced at a discount.
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Most people think of bonds as being appropriate for those who need regular current income without a huge amount of risk. Yet some bonds are structured specifically not to pay income currently. The special ways in which these zero coupon bonds work can make them appropriate for very different uses than the typical fixed-income security. With most bonds, the issuer accepts an up-front payment from investors in exchange for promising to pay interest payments at regular intervals and then repay the principal at maturity.
Zero coupon bonds work a bit differently. As the name suggests, the issuer has no obligation to make any interest payments during the term of the bond. Only at maturity must the issuer repay the face value of the bond. As you can imagine, investors aren't willing to pay the same amount for a zero coupon bond that they would for a bond that pays interest.
Zero coupon bonds are therefore sold at a discount to their face value. There are two very different reasons why various investors like zero coupon bonds. For one group, the absolute certainty of receiving a fixed amount on a fixed date in the future is extremely valuable. Another group of investors likes zero coupon bonds because of their sensitivity to rate changes.
Because all of the return of a zero coupon bond gets incorporated into its price, changes in rates have a more dramatic impact on zero coupon bond prices than with their interest-paying counterparts.
The longer the maturity, the greater the price sensitivity. Therefore, if you want to bet on interest rates moving a particular direction, zero coupon bonds are your best way to maximize profit from any given rate move.
For some investors, being more sensitive to rate changes is a negative rather than a positive. If you don't intend to hold your bond to maturity, you have to stay aware of market fluctuations, and extreme volatility for zero coupon bonds can work against you if rates don't move the way you want. Specifically, if rates rise, they make the value of your zero coupon bond go down, potentially forcing you to sell at a depressed price if your timing is bad.
Another problem with zero coupon bonds is that IRS laws typically force you to recognize taxable income every year. Despite the fact that you don't actually receive an interest payment in cash, the IRS requires you to impute the amount of interest you should have gotten, based on the initial yield. Fortunately, you might be able to avoid this issue by holding zero coupon bonds in a tax-favored account like an IRA. Despite their dangers, zero coupon bonds let you do some unusual things.
Rate speculation can be risky, but the rewards can be impressive if you make the right bet. Meanwhile, if you have specific cash needs at a given time that you don't want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals. The Motley Fool has a disclosure policy. Dan Caplinger has been a contract writer for the Motley Fool since
Rate speculation can be risky, but the rewards can be impressive if you make the right bet. To figure the price you should pay for a zero-coupon bond, first divide your required rate of return by to convert it to a decimal. References Investopedia: Each month, more than 1 million visitors in countries across the globe turn to InvestingAnswers. References Investopedia: On the open market, investors pay higher prices for zero-coupon bonds when they require a lower rate of return and lower prices when a higher rate of return is required. This consequently renders the yield to maturity easier to calculate for zero coupon bonds, because there are no coupon payments to reinvest, making it equivalent to the normal rate of return on the bond.