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A zero-coupon bond is a particular kind of bond that is sold below its face value and does not provide investors with ongoing interest payments. The whole face value of the bond is instead paid to the investors when it matures. This indicates that the difference between the bond's purchase price and its maturity value generates a profit for the investors.
Due to the fact that zero-coupon bonds accrue interest over time to reach their full value, they are also known as accrual bonds or pure discount bonds. For instance, if you spend $600 to purchase a zero-coupon bond with a face value of $1,000 and a maturity of 10 years, you will receive $1,000 at that time, which is the same as an annual interest rate of around 5.26%.
Zero-coupon bonds have some advantages and disadvantages compared to regular bonds that pay interest periodically. Some of the advantages are:
- Given that there is no need to track or reinvest coupon payments, they are simple to compute and understand.
- As there is no chance of missing an interest payment, their risk of default is lower.
- They can provide bigger returns if interest rates decline since they are more sensitive to changes in interest rates in terms of pricing.
- Since there is less demand for them on the secondary market, they have reduced liquidity.
- They have a larger tax burden because, while not receiving any cash until maturity, investors must pay taxes on the imputed interest each year.
- If interest rates rise, their returns are smaller than those of conventional bonds.
Zero-coupon bonds can be issued by various entities, such as governments, corporations, or financial institutions. Some examples of zero-coupon bonds are:
- US Treasury bills: These US government-issued zero-coupon short-term bonds have maturities ranging from a few days to 52 weeks. They are regarded as extremely liquid and safe investments.
- US savings bonds: The US government has issued these 30-year or longer zero-coupon bonds with extended maturities. Since they are exempt from state and local taxes and can be redeemed at any time after one year, they are well-liked by individual investors.
- Strip bonds: These are zero-coupon bonds created by separating the coupons from regular bonds and selling them separately. This gives investors the flexibility to tailor their cash flows and durations to suit their preferences.
If you want a low-risk, long-term investment that doesn't need frequent monitoring or reinvestment, zero-coupon bonds can be a valuable addition to your portfolio. Before investing in them, you should consider their limitations and tax ramifications.
