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Zero-coupon bonds are quite useful in financial planning because they permit you to plan with certainty for specific rates of growth on the monies invested in them, provided that those monies will be left intact until maturity. If, however, you need to liquidate your zero-coupon bonds before their maturity, you will find that since you purchased your bonds, their prices will have moved dramatically in a direction opposite that of interest rates. These bonds have the most volatile price movements of any bonds in their respective credit quality and maturity group because they pay no coupon interest to cushion the blow of any change in interest rates. Another important aspect of zero-coupon bonds relates to their taxation. Income is accrued on zero-coupon bonds even though they do not pay any interest before maturity. If the bond is taxable (that is, it is a U.S. Treasury bond or a corporate bond), you will have to pay annual federal income tax on the accrued income even though you did not receive any cash flow from the bond before maturity. The income is based on the accretion of the bond from the discount price at which you bought it to the par value it will grow to have at maturity. If your bond is a municipal zero-coupon, the accretion is still calculated each year, but the bond's accretion is not taxed at the federal level. (Consult your state's tax laws regarding the taxation of the accretion.) This accretion affects the municipal bond's book value, however, which in turn influences the portion of any capital gain subject to federal income tax. Taxable zero-coupon bonds are often used in retirement plans and in children's custodial accounts because of the predictability of their values at maturity and the fact that income earned in accounts of this sort is generally able to grow tax-deferred or is taxed at a low federal income tax rate. Tax-exempt zero-coupon bonds are often used to form a "Side-IRA," which means that a pool of money is able to grow, free of taxation, with its anticipated use being to enhance the pool of money that is allowed to grow within an IRA. The obvious result is that more money will be available at the time of retirement because of careful planning for tax savings and the continuous compounding of the tax-favored rate of return.Stephanie G. Bigwood, CFP, ChFC, CSA, Assistant Vice President, Lombard Securities, Incorporated, Baltimore, MD
Zero-coupon bonds, sometimes known as zeros, are issued at a deep discount to par value and make no interest payments during their term.
At maturity, the bondholder receives par value, which includes the interest that has accrued since issue. For example, you may purchase a zero-coupon bond with a six-year term for $13,500, and collect $20,000 at maturity.
One advantage of zeros is that you can invest relatively smaller amounts and choose maturity dates to coincide with times you know you'll need the money -- for example, when you expect college tuition bills to come due.
One drawback of zeros, however, is that income taxes are due annually on the interest that accrues, even though you don't receive the actual payment until the bond matures. The exception occurs if you buy tax-exempt municipal zeros, on which no tax is due either during the term or at maturity.
Another drawback is that zero coupon bonds are volatile in the secondary market, so if you have to sell before maturity, you might have a loss.
These bonds get their name -- zero coupon -- from the fact that coupon means interest in bond terminology, and there's no periodic interest.