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Zero Coupon
Bonds
Zero-coupon bonds are
debt obligations; notes are sold at a discount to their face value.
Principle and interest accretes in value, and is paid in full at maturity.
The difference between the discount price and the bond’s face value is the
investor’s profit, earned over the life of the bond. There are no cash
payments paid to the bondholders until maturity. Investors looking for a set
payback at maturity find these instruments of value. Saving for a child’s
education is a typical reason why a young adult would purchase a zero-coupon
bond.
The major drawbacks to
these bonds are:
·
Income tax is due when interest
is accrued, but not paid, resulting in regular cash outflows to pay taxes,
without off-setting cash inflows. This tax penalty discourages the purchase
of these securities in non-tax-deferred accounts.
·
Zeros are
somewhat illiquid and fluctuate in price as interest rates change, more then
regular coupon bonds.
Zero-coupon
bonds are interesting and valuable because they utilize the interest
compounding benefits of the time value of money concept. Some zero-coupon
bonds are also inflation indexed. These bonds are ideally suited for long
tern investors, who can hold them to maturity
Finally, Zero-coupon bonds make good investments in a deflationary
environment.
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