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Zero-coupon bonds are very common, and most trade on the major exchanges. Corporations, state and local governments, and even the U.
Treasury issue zero-coupon bonds. Corporate zero-coupon bonds tend to be riskier than similar coupon-paying bonds because if the issuer defaults on a zero-coupon bond, the investor has not even received coupon payments -- there is more to lose. For tax purposes, the IRS maintains that the holder of a zero-coupon bond owes income tax on the ir that has accrued each year, even though the bondholder does not actually receive the cash until maturity.
The IRS calls this imputed interest. Zero-coupon bonds are usually long-term investments ; they often mature in ten or more years. Although the lack of current income provided by zero-coupons bond discourages some investors, others find the securities ideal for meeting long-range financial goals like college tuition. 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.
Compare Brokers. It also allows an investor to only allocate a small amount of money that has the potential to grow over many years. The interest rate and terms of the bond are set when the bond is initially drafted up. Retrieved Spot market Swaps. Investors can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U. A Primer on Inflation-Linked Bonds.
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.
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Zero-Coupon Bond. While there are some benefits of investing in zero-coupon bonds, they're not the right choice for everyone. When an entity issues bonds, it is essentially borrowing money from investors and agreeing to make interest payments in exchange. It's those interest payments that incentivize investors to buy bonds in the first place.
Zero-coupon bonds, however, don't make interest payments. Rather, investors make money from zero-coupon bonds by buying them for less than their face value and collecting their principal and interest payments together at maturity. In this case, the interest at maturity represents the difference between the purchase price of the bond and its actual face value.
Zero-coupon bonds are a good choice if you're looking to save for a particular milestone in the future. If, for instance, you're hoping to pay for your kids' college in 10 years, you might buy some zero-coupon bonds knowing you're likely to get a certain amount of income from your investment at a fixed time down the line. Similarly, zero-coupon bonds can be a good choice for investors who want to save for retirement.
What is a Zero-Coupon Bond. A zero-coupon bond is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount. A zero-coupon bond does not pay coupons or interest payments like a typical bond does; instead, a zero-coupon holder receives the face value.
While you won't benefit from interest payments along the way, if you time your investment right, you stand to collect a larger sum when the bond matures during your senior years. As is the case with all investments, there are a few negatives to consider as well.
While zero-coupon bonds don't make regular interest payments, you might still be liable for taxes on what's known as the phantom interest that accrues each year. In other words, you might pay taxes each year on the prorated difference between what you paid for your bonds and the total you stand to receive once they mature. There are, however, a couple of ways to avoid this. First, if you hold zero-coupon bonds in your IRA, you won't pay taxes until you begin taking withdrawals. Additionally, if you buy zero coupon municipal bonds, you'll avoid taxes at the federal level.
And if the bonds you purchase are issued by your home state, you'll avoid state and local taxes as well. If you are going to invest in zero-coupon bonds, make sure the issuer has a strong credit rating. If you buy zero-coupon bonds and the issuer defaults, you stand to lose out on that eventual interest, thus rendering your investment not worth your while.
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