What are zero-coupon bonds and how do they work?

Zero-coupon bonds are a unique type of bond that does not pay interest periodically like traditional coupon bonds. Instead, zero-coupon bonds are sold at a deep discount to their face value and gradually increase in value until reaching full face value at maturity. This makes zero-coupons an attractive fixed-income investment option for traders and investors.

Learn about zero-coupon bonds in this article. Familiarise with their benefits, associated risks, significance to traders, and platforms to trade these bonds.

Explaining the idea of zero-coupon bonds

Zero-coupon bonds work differently than regular bonds that make periodic interest payments, known as coupon payments. Here is a comprehensive overview of how zero-coupon bonds function:

• Investors purchase the bonds at a significantly discounted price relative to the face value, often 30-50% lower. This discounted price is known as the original issue discount (OID).
• The bonds then increase in value each year as they approach the maturity date. The increasing value represents the interest accrued on the bond.
• At maturity, typically between 10-30 years from issuance, the investor receives the full stated face value of the bond.
• No periodic coupon payments are ever made on the bond. All interest accrues through the deep OID discount and is received at maturity.
• The difference between the deeply discounted OID purchase price and the face value received at maturity represents the total interest earned on the bond investment.
• For example, a zero-coupon bond with a $1,000 face value might be purchased for $500 originally. At maturity, the full $1,000 face value is received. The $500 interest is earned by holding the bond until maturity.
• The lack of coupon payments allows the interest to compound itself, increasing bond value over time.
• From the issuer's perspective, the lack of periodic interest payments means reduced costs and deferred liabilities until the bond matures.

Zero-coupon bonds across different sectors

There are a few main types of zero-coupon bonds available in the marketplace:

1. US treasury STRIPS

Given the US government's perfect credit rating and exceptionally low default risk, it is considered one of the safest investments. STRIPS stands for Separate Trading of Registered Interest and Principal of Securities.

They are created by separating traditional Treasury coupon bonds into individual principal and interest components that can be traded separately as zero-coupon bonds.

2. Government agency zeros

It was issued by federal government agencies and GSEs (government-sponsored enterprises) like Fannie Mae and Freddie Mac. It is also considered very safe with implied government backing.

3. Corporate zeros

They were issued by corporations in need of financing. Credit risk is higher than government zeros, but yields are higher to compensate investors. Credit ratings allow for assessing corporate default risk.

4. Municipal zeros

State/local governments and municipalities issued it for public works projects. Offer tax-exempt interest income. Credit risk varies based on the municipal issuer's financial standing.

Across all sectors, the zero-coupon bonds share the same underlying structure of a deeply discounted price, no periodic payments, and increasing value over time. The higher the credit rating and financial strength of the issuing entity, the lower the bond's default risk. Government-backed zeros represent the least risky options.

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Advantages of trading in zero-coupon bonds

There are several advantages to zero-coupon bonds as an investment:

• Attractive yields if held to maturity - The original issue discount provides an above-average yield.
• No reinvestment risk - Without periodic coupon payments, there is no need to reinvest at lower prevailing rates.
• Tax advantages - No annual tax liability on the accrued interest since no payments are received until maturity.
• Flexible holding period - The bonds have value if sold on secondary markets before maturity.
• Useful for financial planning - Mature on predetermined dates at full face value.
• Compounding interest - The value compounds over time as interest accrues on itself.
• Market demand - There is strong institutional demand for zero-coupon bonds.

The highest-yielding zero-coupon bonds typically have longer-term maturities and higher credit risk exposure. Government-issued zero-coupon bonds are considered the safest but have lower yields. Ultimately, zero-coupon bonds across sectors share the same basic advantageous features.

Risks associated with zero-coupon bonds

While zero-coupon bonds do offer unique benefits, there are also some risks to consider:

• Interest rate risk: When the broader market sees an increase in interest rates, it can be bad news for zero-coupon bondholders. If market rates rise, the value of zeros may decline, making them less attractive than other interest-bearing securities.
• Liquidity risk: The lack of coupon payments can make zeros harder to sell, especially in secondary markets where investors might be looking for consistent income streams.
• Event risk: A significant negative event for the issuer, such as corporate restructuring or other financial setbacks, may reduce the bond's value and erode investor confidence.
• Credit risk: Default risk increases for longer-term and non-government zeros. If the issuer's creditworthiness deteriorates over time, there's a higher chance they might default on their repayment obligations.
• Inflation risk: Long-term zero-coupon bonds are more susceptible to inflation or recession, lowering actual returns and reducing the bond's future purchasing power.

The level of risk mainly depends on the creditworthiness and financial health of the issuing entity. Government-backed zero-coupon bonds carry virtually no risk of default. Corporate zeros have higher credit risk that rises the longer the maturity date.

Popular uses of zero-coupon bonds

The unique deferred interest structure of zero-coupon bonds makes them suitable for certain financial planning purposes:

Retirement income planning - Zero-coupon bonds can provide guaranteed income in retirement if the maturity date aligns with when funds are needed. Investors can ladder bonds with sequential maturity dates to create a steady retirement income stream.

Large purchases - Zero coupons can fund large future expenses like buying a house, boat, or other major purchases on a predetermined timeline.

Emergency fund - Having zero-coupon bonds on hand provides funds that can be liquidated if an immediate need for cash arises unexpectedly.

Deferred liabilities - Issuing entities use zeros to raise capital now while delaying interest costs until bonds mature. This is useful for governments, municipalities, and corporations with fluctuating cash flows.

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Are zero-coupon bonds a good investment?

Zero-coupon bonds can play a valuable role in an investment portfolio and financial plan when used properly. Their unique attributes can provide portfolio diversification, income planning, emergency reserves, and tax optimization.

However, zeros may not be ideal for investors who prefer regular income streams or want to avoid inflation risk. As with any investment, there are pros and cons to weigh based on individual circumstances and goals.

Tax implications of zero-coupon bonds

The unique structure of zero-coupon bonds also leads to some specific tax considerations:

• No annual income taxes - Since no interest payments are received until maturity, there are no yearly income taxes before maturity.
• Capital gains taxes - If sold before maturity, any gain over the original discount purchase price is taxed as a capital gain. The yield represents interest accrual.
• Interest income taxes - The entire interest earnings are taxed as ordinary income in the year the bond matures and pays out the face value.
• Tax-exempt municipal zeros - No federal and sometimes no state taxes on the imputed interest income.
• Gift/Estate taxes - Can gift zeros without incurring gift taxes on the accrued interest until maturity. Removes future appreciation from estates.

Consulting a tax professional is advised when investing substantially in zero-coupon bonds to ensure accurate tax reporting and optimal use of their tax-deferred features.

Where to buy and sell zero-coupon bonds

For investors, there are several options to purchase existing zero-coupon bonds:

1. Online brokerages - A premier CFD trading platform, markets.com, provides online access to various financial assets, including bonds. In addition, they supply valuable trading resources that offer insightful guidance.
2. Bond dealers - Specialized bond dealers maintain an inventory of various bonds. They can advise on bonds that best fit an investor's criteria.
3. Financial advisors - Advisors can access zeros and provide guidance on integrating them into a financial plan.
4. TreasuryDirect - For direct access to Treasury STRIPS at the most accurate prices with no middlemen.

The majority of zero-coupon bond trading occurs in over-the-counter secondary markets between investors. There are also select occasions where corporates and municipalities issue new zero-coupon bonds to raise capital, providing additional primary market purchasing opportunities.

Bottomline

Zero-coupon bonds offer a compelling investment proposition that combines above-average yields, financial planning utility, tax advantages, and interest compounding. While they come with some inherent risks like any bond, their deferred interest structure makes them a singular fixed-income vehicle suited for specific investor objectives.

Unlike regular bonds, zero-coupon bonds reward patient long-term investors who hold them until maturity.

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When considering “CFD zero-coupon bonds” for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.”