Do zero coupon bonds always sell at a discount?
A zero-coupon bond is a debt security instrument that does not pay interest. Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity.
As a zero-coupon bond does not pay periodic coupons, the bond trades at a discount to its face value.
With a zero, instead of getting interest payments, you buy the bond at a discount from the face value of the bond and are paid the face amount when the bond matures. For example, you might pay $3,500 to purchase a 20-year zero coupon bond with a face value of $10,000.
U.S. Treasury zero coupon bonds are guaranteed by the federal government as to the payment of principal and interest. However, if you sell a Treasury zero coupon bond prior to maturity, it could be worth more or less than the original price paid.
Coupon bonds may trade at a discount, at a premium, or at par. The sensitivity of a bond's price changes in interest rates is the bond's duration. Bonds with higher coupon rates are more sensitive to interest rate changes.
This is an accrual bond that does not pay the interest but trades at a major discount, giving a profit at maturity when the bond is taken out for its total face value.
Zero coupon bonds have no coupon payments over its life and only offer a single payment at maturity.
While you'll be able to buy zeros at deep discounts to face value, you won't receive anything in return for your investment until the term of the bond ends. Along the way, you'll be subject to higher levels of interest rate risk (if interest rates rise) and inflation risk (if prices rise generally in the economy).
As the coupon rate of a zero coupon bond is zero per cent, people investing in such bonds don't get regular interest, but get a deep discount on face value at the time of issuance of such a bond. At the time of maturity, the investor gets the bond redeemed at the face value.
What is a zero coupon bond? A bond that pays no coupons. It only pays the face value on the maturity date.
What is the most common type of zero-coupon bonds?
Zero-coupon bonds are often perceived as long-term investments, although one of the most common examples is a “T-Bill,” a short-term investment. U.S. Treasury Bills (or T-Bills) are short-term zero-coupon bonds (< 1 year) issued by the U.S. government.
Since zero coupon bonds do not pay any periodic interest payments, investors are not required to pay any taxes on the interest income. However, deep discount bonds may have a coupon rate and investors are required to pay taxes on the interest income.
Prior to its maturity date, the price of a zero-coupon bond is always less than its face value. That is, zero-coupon bonds always trade at a discount (a price lower than the face value), so they are also called pure discount bonds.
The annualized rate which they receive on the zero-coupon bond is the same rate at which their money will be automatically reinvested. This is the reason that zero-coupon bonds become extremely popular especially during periods when the market yield is high.
If interest rates go up, it results in a decline in the value of the bond. The bond must, therefore, sell at a discount. Hence the name, discount bond.
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Under what situation can a zero-coupon bond be selling at a premium? Unlike a coupon bond, a zero-coupon bond does not have a periodic cash flow with one lump-sum payment of the face value at its maturity. Consequently, a zero-coupon bond will be always selling at a price less than its face value.
Answer and Explanation: The correct answer is option d. A bond that has no coupons and pays a face value at maturity.
Understanding the Zero Coupon Bond Yield
The yield on Zero Coupon Bonds is simply the discount rate used in the present value calculations for the bond's face value. It signifies the annualised return the investor will earn from the bond if held until maturity.
Although not paid until maturity, income from zero-coupon STRIPS is taxable in the year in which it accrues. Increases in TIPS principal value as a result of inflation adjustments are taxed as capital gains in the year they occur, even though an investor does not collect these gains until TIPS are sold or mature.
Are zero coupon bonds taxed as capital gains?
Zero coupon bonds are subject to capital gains taxes and some zero coupon bonds require investors to pay taxes on the imputed interest that accrues on the bonds each year, even though that interest is not paid until maturity (as part of the bonds' face-value).
If a zero-coupon bond is held for 12 months or more, it is treated as a long-term capital asset. Proceeds on maturity less cost of acquiring the bonds will then be taxed as long-term capital gain.
A zero-coupon bond is a debt security instrument that does not pay interest. Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity.
How do zero-coupon bonds work? The bonds are sold at a substantial discount from the face value, with the full value paid to the buyer years later. Zeros usually come in denominations as low as $1,000 and, depending on the maturity, are sold at discounts from face or par value of 50% to 75%.
What is the benefit of a zero coupon bond? Zero coupon bonds do not make period payments. The bond is purchased at a deep discount price and builds internally until maturity, at which point the bond is redeemed at par.
