Zero-coupon bonds essentially lock the investor into a guaranteed reinvestment rate. This arrangement can be most advantageous when interest rates are high and when placed in tax-advantaged retirement accounts. Some investors also avoid paying taxes on imputed interest by buying zero-coupon municipal bonds.
They are usually tax-exempt if the investor lives in the state where the bond was issued. With no coupon payments on zero-coupon bonds, their value is entirely based on the current price compared to face value. As such, when interest rates are falling, prices are positioned to rise faster than traditional bonds, and vice versa.
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Fixed Income Essentials Current yield vs yield to maturity. Fixed Income Essentials What is the difference between a zero-coupon bond and a regular bond? Partner Links. Related Terms Zero-Coupon Bond A zero-coupon bond is a debt security that doesn't pay interest but is traded at a deep discount, rendering profit at maturity when the bond is redeemed. Constant Yield Method The constant yield method is one way of calculating the accrued discount of bonds that trade in the secondary market.
Many bonds make periodic interest payments during the life of the bond, and then when the bond matures, the principal is returned.
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Instead, investors purchase the zero-coupon bond for less than its face value, and when the bond matures, they receive the face value. On the open market, investors pay higher prices for zero-coupon bonds when they require a lower rate of return and lower prices when a higher rate of return is required.
The higher the risk the bond issuer will go bankrupt and not repay the bond holders, the higher the interest rate you need to compensate for that risk. Also, remember to consider the length of time until the bond matures. The lower the price you pay for the zero-coupon bond, the higher your rate of return will be. Divide your required rate of return by to convert it to a decimal. Add 1 to the required rate of return as a decimal.
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Raise the result to the power of the number of years until the bond matures. Divide the face value of the bond to calculate the price to pay for the zero-coupon bond to achieve your desired rate of return.
First, divide 6 percent by to get 0. Second, add 1 to 0. Third, raise 1.