Zero Coupon Bonds Basics
Zero coupon bonds (also known as zeros) don't give their holders interest rate payments on regular basis. However, the interest rate is accumulated and paid at maturity. Nevertheless, you still pay taxes on the interest throughout you hold the zero coupon bond.
Zero coupon bonds are bought by investors at a deep discount. When the maturity date comes, investors sell it at a full face value. However, you gain the interest that has been accrued through the years.
Maturities of zero coupon bonds vary a lot. It can range from one to a maximum of forty years. On the top of the chart for the most preferred zero coupon bonds are the US Treasury bonds in addition to the bonds issued by corporations and municipalities.
Basic Characteristics of Zero Coupon Bonds
First of all zero coupon bonds are issued at deep discount. Additionally they are redeemed at their full face value. The repayment of zeros can be done before they reach their maturity but only at exceptional cases. Even though you are not paid interest during the year, you are required to pay taxes on it every year. Another characteristic of zeros is their higher volatility as compared to the other types of bonds.
US Treasury Zeros
In order to purchase US Treasury's zeros you should address a qualified financial institution or brokers that sell "STRIPS" (Separate Trading of Registered Interest and Principal of Securities). Thus, you cannot directly purchase the most popular zeros. STRIPS means that a qualified financial institution has purchased an US Treasury issue. The principal and the interest payment have been then separated into two securities. As a result the principal is turned into a zero coupon bond, whereas the normal income is sold to investors that are seeking for a stable cash flow.
The STRIP you have bought from a qualified financial institution or brokers still enjoy the guarantee of the US government. Thus, they represent one of the safest in terms of credit risk investments.
Municipalities and Corporate Zeros
Zero coupons issued by municipalities and corporations are characterized again by deep discount selling and redemption at full face value. On the other hand, they differ from zeros issued by the US Treasury in that that they can be called by their holder before they reach maturity. Additionally, municipal zeros are exempt form federal income taxes as their regular counterparts.
While corporate zeros return the highest yield, they possess the highest risk of default. Additionally, holders of corporate zeros can call them before they reach maturity.
Finally, with the increase of the time during which you hold a zero bond the front-end cost is decreased. Additionally, the result of compounding is enhanced which may faster lead you to the full face value.
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