Zero coupon bonds, also known as discount bonds, may be defined as bonds that do not pay interest during the tenure of the bonds. Instead, investors can purchase the zero coupon bonds at a much lower price than their face value. When a zero coupon bond matures, the investor will receive the face value, which is higher than the price it was originally bought at.
The maturity dates on zero coupon bonds can be set at various lenghts, but generally, the period of maturity is over fifteen years. These long-term maturity dates do have advantages, as the investor can plan for some long-term money requirement like a child’s higher education or post-retirement spending.
The investor has the option to hold on to the bonds until maturity or sell it at any time in the secondary markets. Prices of zero coupon bonds are often volatile in the secondary market and fluctuate sharply compared with other types of bonds. Financial analysts say that the advantage of zero coupon bonds lies in retaining them till maturity instead of off-loading in the secondary market. If for whatever reasons, the investor decides to sell a zero coupon bond, its value will be determined by prevailing market prices, years remaining for maturity and credit worthiness of the bond issuer.
It is important to note that with zero coupon bonds the investor has to pay federal, state, and local income taxes on the notional interest that accrues each year, even though the interest payment is actually received only on maturity. Some investors overcome this tax burden by purchasing municipal zero coupon bonds or buying them inside of tax-advantaged accounts.
There is an inherent threat that the issuer may not provide payment when the bond matures. This risk factor is almost zero if the bonds has been issued by federal or state governments or other government bodies, as the credibility of the concerned government is at stake. The risk factor is real if the issuer is a private organization.
