Zero-coupon bond

From Academic Kids

Zero-coupon bonds are bonds which do not pay interest payment (also known as coupon payments). The bonds are purchased at a discount from what they will be worth when they mature. The holder of a zero coupon bond is entitled to receive a single payment, usually of a specified sum of money at a specified time in the future. Some zero coupon bonds are inflation indexed, and so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond.

In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.

Zero-coupon bonds are considered long-term investments with maturity dates typically starting at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets.

Strip bonds

Dealers may separate the coupons from the bond principal, which is also known as the residue, so that different investors are entitled to the principal and each of the coupon payments. Both the coupons and residue may be sold to investors. Each of these investments then pays a single lump sum, so it is effectively a zero coupon bond. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds.

Dealers normally purchase a block of high-quality and non-callable bonds - often government issues - to create strip bonds. A strip bond has no reinvestment risk because the payment to the investor only occurs at maturity. There is no guarantee the coupon payments on a regular bond can be reinvested at the same or better yield.

The impact of interest-rate fluctuations on strip bonds is more pronounced than a bond that has both coupons and residue - particularly when the term to maturity is long. Strip bonds are available from investment dealers maturing at terms even up to 30 years but sometimes longer (over 90 years for some bonds in Canada).

In Canada, investors may purchase packages of strip bonds, so that the cash flows are tailored to meet their needs in a single security. These packages may consist of a combination of interest (coupon) and/or principal strips.

In New Zealand, bonds are stripped first into two pieces - the coupons and the principal. The coupons may be traded as a unit or further subdivided into the individual payment dates.

In most countries, strip bonds are primarily administerd by a central bank or central securities depository. An alternative form is to use a custodian bank to hold the underlying security and a transfer agent/registrar to track ownership in the strip bonds and to administer the program. Physically created strip bonds (where the coupons are physically clipped and then traded separately) were created in the early days of stripping in Canada and the U.S., but have virtually disappeared due to the high costs and risks associated with them.

History

Zero coupon bonds were introduced in 1982.

Taxes

Even though zero's don't pay periodic interest, the holder may be liable for imputed income. [1] (http://www.sec.gov/answers/zero.htm) Because of this, zero's should generally be held in tax-deferred retirement accounts, to avoid paying taxes on future income.de:Nullkuponanleihe it:Obbligazione zero-coupon

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