For some investors, that proposition has a strong appeal. Who Would Want Them? If you are retired and looking to generate a steady stream of income, zero-coupon bonds are probably not high on your list of potential investments. On the other hand, if you need a specific amount of income on a specific date in the future, they may be the perfect choice. Consider, for example, the future college funding needs of a young child.
If your goal is to help the child pay for an education , it is fairly easy to predict the date on which the child will need the money. Purchasing zero-coupon bonds that mature on the date the child will need the money can be a convenient way to help cover the expense. Zero-coupon bonds are also appealing for investors who wish to pass wealth on to their heirs but are concerned about income or gift taxes.
The bonds will provide income for the children without increasing their tax liabilities. Zero-coupon bonds are also an interesting option for investors with little interest in watching the financial markets move up and down. You just buy the bond and wait for it to mature. Issues and Issuers Zero-coupon bonds come in many varieties.
Two of the most common include the issuer and the tax status. Zero-coupon bonds may be issued by federal, state or local governments or by corporations.
Perhaps the version most familiar to many investors is the old Series EE savings bonds issued by the U. These bonds were popular because they could be purchased in small denominations. While the savings bond program has been changed, and these bonds are no longer available, the concept is still a valid example of how zero-coupon bonds work.
From a tax perspective, zero-coupon bonds issued by government entities generally come with an attractive degree of exemption from income tax. For example, some of these bonds are triple tax-free, as the income they generate is exempt from income tax at the federal, state and local levels. Various local municipalities are significant issuers of zero-coupon bonds as they seek to raise capital to support infrastructure and other projects. Others offer limited tax exemption. In either case, paying less in taxes is always good news, because it puts a greater percentage of the earnings generated by the investment into investors' pockets instead of going to the tax man.
Some zero-coupon bonds are issued by corporations. While earnings from these bonds are taxable, the interest rate they offer is likely to be higher than the rate offered on a tax-free bond of similar maturity and credit quality. In a twist on these offerings, some zero-coupon corporate bonds can be converted into shares of stock in the issuing company. Zero-coupon bonds can also be created by banks and brokerage firms. These entities take a regular bond and remove the coupon to create a pair of new securities.
Unique Characteristics Zero-coupon bonds are bought for a fraction of face value. If issued by a government entity, the interest generated by a zero-coupon bond is often exempt from federal income tax , and often from state and local income taxes too.
If purchased from a corporation, the interest is not paid until maturity, but investors must pay income tax each year on the earnings that they have not yet received. For this reason, zero-coupon bonds issued by corporations are often purchased in tax-deferred accounts such as Individual Retirement Accounts. Risks Zero-coupon bonds may not reach maturity for decades, so it is important to make sure that any bonds purchased have been issued by creditworthy entities.
Some of them are issued with provisions that permit them to be paid out called before maturity. Investors counting on a specific payout on a specific date should be aware of these provisions to avoid the implications of what professional investors refer to as "call risk". Also, the bonds' daily prices fluctuate on the open markets, so investors who sell them prior to maturity may receive more or less money than they originally paid for the bonds.
Of course, if held until maturity, the payout will be predetermined and does not change. How to Buy Zero-coupon bonds issued by the federal government can be purchased directly from the government at the time they are issued. After their initial issuance, they can be purchased on the open market through a brokerage account just like other bonds.
Other types of zero-coupon bonds can also be purchased using a brokerage account. Financial advisors often provide guidance for investors interested in purchasing zero-coupon bonds. Of course, a little bit of personal due diligence is always a good idea. This information will provide some insight into the value of the tax deferral, and it may help you narrow down the field of potential investments.
The Bottom Line Like most investment vehicles , zero-coupon bonds are like tools in a toolbox. Picking the right tool for the job can help you achieve your objective. A little time and effort, to make sure you understand the investment and have made the right choice for your needs, can go a long way toward helping you feel comfortable and confident enough to wait many years or decades for your investment to mature and pay out your earnings. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews.
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Passive investing is an investment strategy that limits buying and selling actions. Passive investors will purchase investments How much a fixed asset is worth at the end of its lease, or at the end of its useful life.
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