In the world of investing there are many terms that sound more complicated than they actually are. Zero-coupon bonds are one of those terms. Here’s a quick low-down on what they are and the pros and cons of using them as an investment tool.
A bond is an investment tool where someone loans money to a company or a municipality for a specified period of time at a specified interest rate. For example, you could purchase a municipal bond where you loan money to a city project. The bond matures in five years and at that point you get the money you loaned them back plus interest. The interest rate is called a coupon. The risk with a bond comes in the fact that the interest rate can fluctuate so you may not make as much money on the investment as you’d like.
A zero-coupon bond means that no interest is paid out on the bond. So what’s the benefit, you ask? The benefit of a zero-coupon bond is that while there’s no interest paid out, they’re sold at a discount. For example, you could buy a zero-coupon bond worth $1000 for $100 and when the bond comes due, you’ll be paid $1000. So while you’re not paid interest during the loan, you do make money on the investment.
Zero-coupon bonds can be issued from the US Treasury, corporations and municipalities. Of the three, bonds from the US Treasury are the most popular – perhaps because they have the lowest risk.
The risks associated with a zero-coupon bond include:
* Some issuers may call them before they mature
* You have to pay tax on the interest as it accrues annually even though you don’t receive it until maturity
* Corporate zero-coupon bonds carry the most risk of default; however, they often pay the highest yields
If you’re interested in investing in zero-coupon bonds, you cannot buy them from the US Treasury specifically but rather have to purchase them from a broker or a financial institution. They still carry the same security as if you would have purchased them from the Treasury so there’s no additional risk. And they carry with them the added benefit that you can redeem them before they reach full maturity.
Bonds and zero-coupon bonds can be an effective investment strategy in your portfolio. Check with your broker or financial planner to see what they offer. Always make sure you understand the terms of the agreement, the risk, and the potential rewards before you make an investment of any kind. To your success!
