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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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