Zero-Coupon Bonds

Zero-coupon bonds (“zeros”) represent a type of bond that does not pay interest during the life of the bond. Instead, investors buy these bonds at a steep discount from the “face value” (the amount a bond will be worth when it matures). When the bond matures, investors will receive single payments equal to their initial investments plus the accrued interest.

Available in the secondary market and issued by the U.S. Treasury, corporations, and state and local government entities, zeros typically have long maturity dates, such as 10, 15, or more years. The initial price of a zero depends on the number of years to maturity, current interest rates, and the risk involved. For example, a zero-coupon bond with a face value of $5,000, a maturity date of 20 years, and a 5% interest rate might cost only a few hundred dollars. When the bond matures, the bondholder receives the face value of the bond ($5,000 in this case), barring default.

The value of zero-coupon bonds is subject to market fluctuations. Because these bonds do not pay interest until maturity, their prices tend to be more volatile than are bonds that make regular interest payments. Interest income is subject to ordinary income tax each year, even though the investor does not receive any interest until the bonds mature.

The return and principal value of bonds fluctuate with changes in market conditions. If sold prior to maturity, a bond may be worth more or less than its original cost.

 

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright © 2012 Emerald Connect, Inc.
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All Investing involves risk including the potential loss of principal. No investment strategy such as asset allocation can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

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Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors. Securities sold or redeemed prior to maturity may be subject to a substantial gain or loss. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. Vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

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