Zero Coupon Bonds

Zero Coupon Bonds Defined

Zero Coupon bonds, also known as "zeros", is a unique bond in that the bond holder does not receive coupon payments. Zero coupon bonds are sold at deep discounts to par and then mature at par. The spread between the purchase price and par is effectively the accrued interest. The yield on a zero includes interest on interest, or compounding interest. The key difference between a zero coupon bond and a treasury bond is the reinvestment risk. Zero coupon bonds automatically reinvest the coupon back into the bond at the yield to maturity rate and result in guaranteed returns. Alternatively, treasury bond coupon reinvestment is done at the prevailing market rate and therefore can have higher or lower yields to maturity depending on the interest rate environment.

A buyer of a zero coupon bond should be aware of a few key potential pitfalls; first, zero coupon bonds are subject to imputed interest. Imputed interest is actually interest paid but not received. Zero's work best in tax sheltered or tax deferred accounts. Secondly, zero coupon bonds expose the investor to higher levels of interest rate risk. Remember, zero coupon bonds have a greater duration than regular coupon bearing bonds and therefore have greater interest rate risk.

The zero coupon bond holder will incur a significant increase in risk if they do not plan on holding the security till maturity. Price swings will be amplified as interest rates move, especially with longer term zero coupon bonds.

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