Zero-coupon bonds do not have interest coupons attached (interest at a particular rate that is sent to the bondholder on a regular basis), nor do the issuers make annual interest payments. Investors who purchase them, therefore, do not receive interest. Instead, they purchase a bond at a price lower than the bond’s $1,000 par value and can redeem it for par on the maturity date. The “interest” earned on the bond is the difference between the price paid initially and the amount received at maturity.
Zero-coupon bonds are issued both by corporations and municipalities, and they may be created by broker-dealers from other types of securities, including those issued by the federal government.
Even through interest is not paid until the bond matures, the investor who owns corporate or government zero-coupon bonds owes income tax each year on a portion of that amount, just as tough it had been received in cash. Because the annual interest is not prorated on a straight-line basis and the investor is apportioned a different amount each year, the issuer of the bond is required to send the investor an IRS Form 1099 annually showing the amount of interest subject to taxation. Final determination of the amount of taxable interest may be made by the IRS.
Long-term zero-coupon bonds issued by various broker-dealers and based on securities issued by the federal government are called STRIPS (Separate Trading of Registered Interest and Principal of Securities).
Because they do not pay interest until maturity, zero-coupon bonds are more volatile in price than other fixed income securities. Deeply discounted long-term bonds react more sharply to interest rate fluctuations than do short-term bonds and bonds selling near par (the value they will be redeemed for, i.e. $1,000). Zero-coupon bonds are the ultimate in deep-discount, long-term debt. In effect, the zero-coupon bond locks in an unchanging interest rate for its entire life.
If that rate is relatively good, investors will pay dearly to receive it. If the rate is relatively low, investors will not buy the securities unless they are selling at an especially deep discount. Therefore, a decrease or an increase in interest rates will cause a sharper decrease or increase in the price of a zero-coupon bond than in the price of an interest-bearing bond. Finally, one of the best reasons investors buy zero-coupon bonds is that because investors are willing to forgo regular interest payments and therefore the bonds pay a higher interest rate.
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Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.