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Why Zero Coupon Bonds May Be Better

By Jason Markum

Investing in the stock market can be tricky, heck investing in general is tricky. But one area of investing that I’ve found people to have more than average confusion over is the bond market. Many people just don’t understand bonds and that might be because of the math that’s involved in calculating their value.

There is a strange inverse relation to price and yield that confuses the heck out of most individual investors. When the price of a bond goes up, the yield (or effective interest rate that the bond pays) goes down.

And the opposite holds true as well; when the bond’s yield goes up, it’s price goes down. Have I confused you yet? It doesn’t really matter anyway because today I want to talk mainly about zero coupon bonds and try to explain or convince you why they may be better to invest in than other types of bonds.

Zero coupon bonds work differently than most bonds because they don’t pay any cash interest to the owner. Instead you buy them at a price far below their face value and then you hold them until they are due, at which point you get paid their full face value.

I suppose technically you are getting paid interest but realistically speaking that interest is only the difference between the discount that you paid at the beginning and the face value that the company eventually pays out.

They are very similar to US savings bonds or treasury bills in that there is no ongoing interest payments annually or semi-annually like a regular bond. It’s just a matter of the difference between the discount original price and the final face value that gets paid.

Many times the zero coupon bonds offer some of the higher or highest overall returns than other US government securities. And another good thing about them is that they pay a fixed rate of return that reinvests your interest income for you.

Zero coupon bonds are great for funding things like tax-free or tax-deferred investment vehicles, and many people use them in qualified pension plans and sometimes in profit sharing retirement plans. IRAs as well as college savings accounts are other good places to stick zero coupon bonds.

There is one downside and it involves taxes. If you invest in zero coupon bonds in a tax-deferred account like an IRA, then you don’t have anything to worry about but if you purchase them outside of tax deferred accounts then you may run into tax problems.

Even though the zero coupon bond doesn’t pay interest, the IRS treats them as if they did; meaning you will owe taxes on that ghost interest income every year even though you’re not receiving it until the bond matures many years in the future. There are exceptions such as municipal bonds, but for the most part this holds true.

All in all zero coupon bonds are a great investment vehicle for many different situations and I suggest you look into them in greater detail so that you can take advantage of them today.

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