5

Why will someone prefer to buy a zero coupon bond rather than a >0% coupon bond?

6

To make a zero coupon bond pay, it is sold at a discount to face value. For instance, if the bond is worth $1,000 at maturity, it might be sold at $970. Then the buyer gets a gain of $30 (a little over 3% on $970) when the bond matures.

Treasury bills are sold as zero coupon "bonds." One advantage is that if you buy, say, a six month bill in November 2011, you don't get a gain on it until May, 2012, and don't have to pay tax on it until 2013.

Long term bonds can be made into zero coupon bonds by "stripping" the coupons. They are then re-sold at the appropriate discount. The advantage is that your interest rate is determined by the discount. You don't have to worry about reinvesting the interest (coupons) at a different, and possibly lower rate.

2

It's the early 80's. Long term rates are at 14% or greater. When you spend $1000 to get $140 per year you may be happy, but you also have an issue of reinvesting that coupon payment. By spending the same $1000 for a zero coupon bond, you'll buy nearly $51,000 face value for the final payment 30 years hence. This is an example of how crazy compound interest is over this time span, and high rate.

  • Do you know of any zero-coupon bonds that yield 14%? I was told that COFINA bonds do, but I am not sure how to buy them. – Geo Nov 5 '11 at 2:25
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    You mean now? No. 3% or so is far less impressive even over 30 years. – JoeTaxpayer Nov 5 '11 at 3:04
  • @Geo there are some Puerto Rico Tax Free zero coupon bonds you can buy with a YTM over 14% maybe over 20%. However, that assumes that they will be paid off in full. The market is saying that is very unlikely and therefore it may turn out that instead of getting 20% your rate of return is negative. – Bob May 12 '18 at 14:28
-1

I buy tax free bonds and I buy mostly zero coupon bonds. When I buy a bond, I normally want the following:
1) The interest is tax free.
2) A good bond rating.
3) Long term so I can get a good interest rate.
4) Non-Callable.
Given all these requirements, the only bonds that seem to be available to me are zero coupon bonds.

Bob

  • 1
    Zero coupon bonds do not pay interest. Profits/Losses are treated as income for tax purposes, not as interest or capital gains, and as such are subject to taxation. – Nick R May 12 '18 at 16:55
  • For tax purposes, zero coupon bonds do pay interest. The tax payer should recognize that interest income on his/her tax return using the accrual method. In addition, some zero coupon bonds are tax free because they are issued by authorized that have the right to issue tax free bonds. – Bob May 18 '18 at 13:42
  • Hi! See for example the SEC site for a detailed description of these issues. – Nick R May 18 '18 at 13:55
  • @Nick R, Is it your position that if I buy a corporate zero coupon bond due in 10 years, then I do not have to pay any tax until I redeem the bond? I claim that I must pay tax every year I hold the bond. I do agree with the following statement. On a cash basis, zero coupon bonds do not pay interest. That statement is consistent with my earlier comments. – Bob May 18 '18 at 13:59
  • For tax purposes, each year you would declare an "accrued" amount due - roughly nominal price minus buy price divided by number of years. This is not interest since interest is paid net of a withholding tax. It is treated as untaxed income. – Nick R May 18 '18 at 14:07

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