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Negotiable Financial Instruments > This page Zero-Coupon Instruments If you are seeking a safe, reliable investment that provides attractive, predictable returns, zero-coupon instruments can be an ideal solution. Their many advantages include the following:
How zero-coupon instruments work Zero-coupon instruments do not make periodic interest payments. Instead, the interest accrues and is paid in a lump sum at maturity. You buy zero-coupon instruments at substantial discounts to their par value (face value) at maturity. When each instrument matures, you receive its par value, which represents your original principal investment and the compound interest you earned, but did not receive, during the life of the instrument. Generally, the further away the maturity date, the lower the purchase price as a percentage of that future value. The value of a zero-coupon instrument increases as the maturity date approaches, eventually reaching par value at maturity. Ideal for long-term financial planning Zero-coupon instruments, which were introduced in the early 1980s, have grown steadily in popularity among investors who do not need current income but want a conservative investment that offers an assured return on a specific future date. Zero-coupon instruments are ideal for this purpose. You can select maturity dates that match the time you will need the money. Perhaps for a home purchase, your child's education or your retirement and know precisely how much money you will receive. Zero-coupon instruments eliminate the reinvestment risk normally associated with traditional coupon-bearing bonds. If interest rates decline after you invest in a coupon-bearing bond and you reinvest your interest payments at lower rates than the original investment yield, your total effective yield, over time, will be lower. In addition, if you are investing relatively small interest payments, your choices for reinvestment will be limited. The semiannual interest payment on a $1,000 bond with a 7% coupon, for example, would be only $35. With zero-coupon instruments, you don't need to worry about reinvesting periodic interest payments at a lower rate, because the interest automatically compounds over the life of the instrument. You lock in a true compound rate of interest for the entire period. The trade-off is that you don't get the benefit of being able to reinvest interest payments at a higher rate, in the event that interest rates rise after your date of purchase. The following zero-coupon instruments are recommended:
Tax considerations for U.S. investors A portion of a zero-coupon instrument's discount from face value. That is, the imputed interest is taxable as ordinary income each year, even though you don't receive the cash payment until maturity. That's why zero-coupon investments are best suited for tax-advantaged accounts, such as individual retirement accounts (IRAs), BasicSM (Keogh Plus) plans and custodial accounts for minor children. While the future of zero-coupon instruments, if held to maturity, is fixed and will not change, their market values vary with interest-rate changes prior to maturity, just like all fixed-income securities. Further to the above, zero-coupon instruments fluctuate more sharply in price than conventional coupon bonds.
The longer the instrument's maturity, the greater the price fluctuations will be. For further information, contact us at EagleTraders.com. Recommended further reading: |