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Zero Coupon Bonds

ZERO COUPON BONDS
Zero coupon bonds are bonds that do not pay periodic interest. They are purchased at a deep discount, and the investor receives the face value which represents principal and interest when the bond is redeemed at maturity.

Zero coupon bonds basically have two advantages over coupon bearing bonds:
1 - A relatively small investment is required to purchase zero coupon bonds
2 - The investor is assured of a specific yield throughout the term of the investment.

One of the problems an investor may face with a coupon bearing bond is how to reinvest the interest earned. For example, assume a client has a coupon bearing bond paying 12%, and he or she receives interest of $1,200. If the prevailing interest rate at the time is 8%, the client may not be able to reinvest
the interest so that it earns 12%. The owner of a zero coupon bond does not bear that reinvestment risk. The compound yield to maturity is established when the bond is purchased; the investor knows exactly what the return will be.
 
The down side is, of course, that the investor receives no interest until the bond matures. This drawback is compounded by the fact that, unless the bond is tax exempt, accrued interest is taxable to the investor annually. Because of this, zero coupon bonds are popular investments in IRAs, Keoghs, qualified
profit sharing plans, and other tax deferred retirement plans. They also can be good vehicles for custodian accounts and trusts for children who are in a low tax bracket.
 
The market value of zero coupon bonds will fluctuate with interest rates.  Therefore, an investor must plan to hold the bond to maturity to be assured of
receiving the face amount. Also, there is some risk that the issuer of the bond will default, and will not honor the bond at maturity. The potential loss is greater to the holder of a zero coupon bond than it is to an investor in a coupon bearing bond that has paid interest periodically.

Some zero coupon bonds, however, carry virtually no risk of loss, because they are backed by the U.S. government or insured by the Federal Deposit Insurance Corporation (FDIC).

TYPES OF ZERO COUPON BONDS
1. Zero Coupon Treasury bonds:
 These are actually U.S. Treasury bonds or notes that have been stripped of their coupons by the Treasury or by a brokerage house.  A broker, bank, or other custodian, then markets the stripped bonds at a discount, and the purchaser receives the face amount at maturity.
2. Zero Coupon Certificates of Deposit:
These are issued by banks, and are insured up to $100,000 by the FDIC. Zero coupon CDs are offered at a larger discount than are zero coupon Treasury bonds, thereby providing the investor with greater return on investment.
3. Zero Coupon Corporate Bonds:
These are issued by corporations and provide a greater rate of return than stripped Treasury bonds or zero coupon CDs because the investor assumes more risk. They are not insured against the issuer defaulting at maturity.
4. Zero Coupon Municipal Bonds:
These are zero coupon bonds that provide interest income that is not subject to Federal, and, in many cases, state taxation, They alleviate the problem of the investor having to report interest income that he or she has not received.

FUTURE VALUE OF $1,000.00 SINGLE DEPOSIT:

YEAR	5%	8%	15%
1	$1,050.00	$1,180.00	$1,150.00
2	$1,102.00	$1,166.00	$1,323.00
5	$1,276.00	$1,469.00	$2,011.00
10	$1,629.00	$2,159.00	$4,046.00
20	$2,653.00	$4,661.00	$16,367.00

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