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Home » Investment Planning » Bonds and Security » Zero Coupon Bonds Investment

Zero Coupon Bonds Investment

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest, which is discussed below.

The maturity dates on zero coupon bonds are usually long-termómany donít mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a childís college education. With the deep discount, an investor can put up a small amount of money that can grow over many years.

Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. In addition, although no payments are made on zero coupon bonds until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying tax on the imputed interest by buying municipal zero coupon bonds (if they live in the state where the bond was issued) or purchasing the few corporate zero coupon bonds that have tax-exempt status.

Types of zero coupon bonds

Also known as strip bonds, there are four types of them. The first one is known as zero coupon municipal bonds. Also known as government zero coupon bonds, they have the advantage of not being affected by federal taxes. And in some cases, they are not even affected by state or local taxes. As a consequence, the Return Over Investment (ROI) may be higher than other kind of zero coupon bonds. Another advantage is that they don't require a huge amount of capital. You only need a minimum of US$5000, an easily achievable figure in the USA. Additionally, it is rated as an A or even triple A investment, which has a high degree of liquidity. This is very practical if you need the money and wish to sell your securities. All of these reasons have created a market of US$124 billion for this type of bond.

Another kind is the zero coupon corporate bond. Although their ROI is higher than any other kind of bond, they are affected by federal taxes. But there are some other advantages. You may choose a wide portfolio of bond investments for you or your clients (many companies issue zero coupon bonds), they have a fair liquidity and are well ranked as instruments for investment.



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