How do investors make money on zero-coupon bonds?
These bonds are issued at a deep discount and repay the par value, at maturity. The difference between the purchase price and the par value represents the investor's return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.
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 the investor will receive when the bond "matures" or comes due.
The Zero Coupon bonds eliminate the reinvestment risk. Zero-Coupon bonds do not let any periodic coupon payments, and hence a fixed interest on Zero Coupon bonds is guaranteed. Fixed returns: The Zero Coupon bond is a perfect choice for those who prefer long-term investment and earn a lump sum.
How are investors in zero-coupon bonds compensated for making such an investment? Such bonds are purchased at a discount, below their face value.
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.
General Advantages of Zero-Coupon Bonds
Then there are the tax exemptions. If issued by a government entity, the interest generated by a zero-coupon bond is often exempt from federal income tax, and usually from state and local income taxes too. Various local municipalities are significant issuers of zero-coupon bonds.
Pension funds and insurance companies like to own long maturity zero coupon bonds because of their high duration. That means that the bonds' prices are particularly sensitive to changes in the interest rate, and so offset, or immunize, the interest rate risk of the firms' long-term liabilities.
But not all bonds have coupon payments. Those that do not are referred to as zero-coupon bonds. These bonds are issued at a deep discount and repay the par value, at maturity. The difference between the purchase price and the par value represents the investor's return.
Zero-coupon bonds offer unique investment opportunities for various investor profiles, with their predictable returns, lower initial investments, and lack of reinvestment risk. However, these bonds also present certain challenges, such as interest rate risk, credit risk, and tax implications.
Zero-coupon bonds don't make interest payments, but instead trade at a discount, rendering full face value at maturity. Their lack of periodic payments removes the risk of potentially needing to reinvest coupons at lower rates. Non-callable bonds cannot be redeemed early by the issuer.
How does the investor make profit from bonds?
In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..
The basic method for calculating a zero coupon bond's price is a simplification of the present value (PV) formula. The formula is price = M / (1 + i)^n where: M = maturity value or face value. i = required interest yield divided by 2.
Zero-coupon bonds, which are issued by the U.S. Department of the Treasury, have no coupon reinvestment risk because they have no periodic coupon payments, interest being paid in full when the bond matures.
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.
If the needed rate of return is negative, a zero-coupon bond can only sell at a premium.
Answer and Explanation: The correct answer is option d. A bond that has no coupons and pays a face value at maturity.
A zero coupon bond generally has a reduced market price relative to its par value because the purchaser must maintain ownership of the bond until maturity to turn a profit. A bond that sells for less than its par value is said to sell at a discount.
Bonds with higher coupon rates are more attractive for investors since they provide higher yields. The coupon rate is calculated by taking the sum of all the coupons paid per year and dividing it with the bond's face value.
T-bills are zero-coupon bonds usually sold at a discount, and the difference between the purchase price and the par amount is your accrued interest.
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).
Why do traders love zero-coupon 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.
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.
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).
Treasury bills are also known as zero coupon bonds, meaning unlike bonds and notes, they don't pay a fixed interest rate. Instead, Treasury bills are sold at a discount rate to their face value.
Tax-exempt zero coupon bonds may be subject to state and local taxes. While these bonds are exempt from federal income tax, they may still be subject to state and local taxes. Investors should carefully consider their tax situation before investing in these bonds.
