Zero-coupon bonds

Definition

Zero-coupon bonds are debt securities that do not pay interest during their lifetime. Instead, they are issued at a discount to their face value and provide a return to the investor when they mature, as the bond is redeemed for its full face value. This unique structure distinguishes them from traditional bonds, making them appealing for specific investment strategies, particularly in long-term planning.

5 Must Know Facts For Your Next Test

1. Zero-coupon bonds are often issued by corporations, municipalities, or the government and can have varying maturity lengths, typically ranging from 1 to 30 years.
2. Investors purchase zero-coupon bonds at a significant discount; for example, a bond with a face value of $1,000 might be sold for $600, with the difference representing the investor's return.
3. These bonds do not provide periodic interest payments, which means they are more sensitive to changes in interest rates compared to traditional bonds.
4. Zero-coupon bonds are often used in specific financial strategies, such as saving for future expenses like education or retirement, due to their predictability in terms of final payout.
5. Because zero-coupon bonds accrue interest over time but do not pay taxes on that interest until maturity, they can be an attractive option for tax-deferred accounts.

Review Questions

• How do zero-coupon bonds differ from traditional coupon-paying bonds in terms of structure and investor returns?
  • Zero-coupon bonds differ from traditional coupon-paying bonds primarily because they do not make periodic interest payments. Instead, they are sold at a discount and the investor receives a single payment at maturity that equals the face value. This structure means that the return on investment comes solely from the difference between the purchase price and the amount received at maturity.
• Evaluate the potential advantages and disadvantages of investing in zero-coupon bonds compared to other types of bonds.
  • Investing in zero-coupon bonds can offer advantages such as predictable returns at maturity and the ability to lock in a fixed yield over a long period. However, disadvantages include their sensitivity to interest rate fluctuations and lack of liquidity since they do not provide cash flow during their term. Additionally, because they don't pay periodic interest, investors must consider the tax implications of accruing interest that will not be taxed until maturity.
• Analyze how zero-coupon bonds can be integrated into an investment strategy focused on long-term goals like retirement or education funding.
  • Incorporating zero-coupon bonds into an investment strategy for long-term goals like retirement or education funding allows investors to benefit from their predictable growth over time without the concern of fluctuating cash flows. Since these bonds mature at a known date with a known payoff, they can align well with specific future financial needs. For instance, an investor might purchase zero-coupon bonds maturing when college tuition is due, ensuring funds are available at that time without worrying about market volatility or reinvestment risk.

Related terms

maturity date: The date on which a bond's principal amount is repaid to the bondholder and interest payments cease.

discount bond: A bond that is sold for less than its face value, typically because it does not pay periodic interest.

yield to maturity: The total return anticipated on a bond if it is held until it matures, accounting for interest payments and the difference between the purchase price and face value.