The greater the length of time until the bond matures, the less the investor pays for it, and vice versa. The maturity dates on zero coupon bonds are usually long term, with many having initial maturities of at least 10 years.
With the bond's deep discount, an investor can put up a small amount of money that can grow over many years. Investors can choose zero coupon bonds that are issued from a variety of sources, including the U. Most zero coupon bonds trade on the major exchanges. Your Money. Personal Finance. Financial Advice.
Popular Courses. Login Advisor Login Newsletters. 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, rendering profit at maturity when the bond is redeemed for its full face value. A zero-coupon bond is also known as an accrual bond. The price of a zero coupon bond can be calculated as: The amount of time involved for a zero-coupon bond to reach maturity depends on whether the bond is a short-term or long-term investment.
A zero-coupon bond that is a long-term investment generally has a maturity date that starts around 10 to 15 years. Zero-coupon bonds that are considered short-term investments typically have a maturity that is no more than one year. Such short-term bonds are usually called bills. For instance, a retired investor seeking to maintain a steady flow of income sees little use for zero-coupon bonds.
However, a family saving to buy a vacation retirement home could benefit significantly from a zero-coupon bond with a or year maturity. A zero-coupon bond may also appeal to an investor seeking to pass on wealth to his heirs.
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Zero-coupon bonds issued in the U. Zero-coupon bonds often input receipt of interest payment, or phantom income, despite the fact the bonds do not pay periodic interest. For this reason, zero-coupon bonds subjected to taxation in the U. 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.
Zero-coupon bond - Wikipedia
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.
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Dan Caplinger has been a contract writer for the Motley Fool since As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world. Follow DanCaplinger. Skip to main content Helping the world invest better since
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