Some zero-coupon bonds are issued as such, while others are bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price much more than coupon bonds.
A bond is a portal through which a corporate or governmental body can raise capital.
When a bond is issued, investors purchase the bonds, and in effect, act as lenders to the issuing entity. The investors earn a return in the form of coupon payments made annually or semi-annually throughout the life of the bond. When the bond matures , the bondholder is repaid an amount equal to the face value of the bond.
If a corporate bond is issued at a discount , this means investors can purchase the bond below its par value.
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But not all bonds have coupon payments. Such bonds are referred to as zero coupon bonds. These bonds are issued at a deep discount and repaid the par value at maturity. The difference between the purchase price and the par value represents the investor's return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.
The interest earned on a zero-coupon bond is an imputed interest , meaning that it is an estimated interest rate for the bond, not an established interest rate.
BEN CARLSON, CFA
So, although no coupon payments are made on zero coupon bonds until maturity, investors may still have to pay federal, state, and local income taxes on the imputed or phantom interest that accrues each year. Purchasing a municipal zero coupon bond, buying zero coupon bonds in a tax-exempt account, or purchasing a corporate zero coupon bond that has tax-exempt status are a couple of ways to avoid paying income taxes on these securities. 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. Fixed Income Essentials.
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A zero coupon bond always has a duration equal to its maturity; a coupon bond always has a lower duration. Strip bonds are normally available from investment dealers maturing at terms up to 30 years. For some Canadian bonds the maturity may be over 90 years.
In Canada, investors may purchase packages of strip bonds, so that the cash flows are tailored to meet their needs in a single security. In New Zealand , bonds are stripped first into two pieces—the coupons and the principal. The coupons may be traded as a unit or further subdivided into the individual payment dates. In most countries, strip bonds are primarily administered by a central bank or central securities depository. Physically created strip bonds where the coupons are physically clipped and then traded separately were created in the early days of stripping in Canada and the U.
Pension funds and insurance companies like to own long maturity zero-coupon bonds because of the bonds' high duration. This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate, and therefore offset, or immunize the interest rate risk of these firms' long-term liabilities. Alternatively, when purchasing a zero coupon bond issued by a U. Zero coupon bonds were first introduced in the s, but they did not become popular until the s.
The use of these instruments was aided by an anomaly in the US tax system, which allowed for deduction of the discount on bonds relative to their par value. This rule ignored the compounding of interest and led to significant tax-savings when the interest is high or the security has long maturity. Although the tax loopholes were closed quickly, the bonds themselves are desirable because of their simplicity. In India, the tax on income from deep discount bonds can arise in two ways: interest or capital gains.
It is also a law that interest has to be shown on an accrual basis for deep discount bonds issued after February From Wikipedia, the free encyclopedia. This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed.
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