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The Financial Planning Center Comprehensive Financial Planning
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How a Zero-Coupon Bond Works |
The following information on Zero-Coupon Treasury Bonds was designed to give investors a basic understanding on the subject listed below.
The information provided on Zero-Coupon Treasury Bonds should not be construed as investment advice, tax advice or a recommendation to purchase any security. Always consult a licensed professional and your personal tax advisor to determine if Zero-Coupon Treasury Bonds are right for you.
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What is a Zero-Coupon Treasury Bond? How a Zero-Coupon Bond Works Back by the full faith and credit of the U.S. Government Be Aware of the Taxation Before You Invest Questions to Ask Before You Open an Investment Account
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Zero-coupon treasury bonds (STRIPS) are purchased at a discount price below the face (par) value of $1,000 and are noncallable. When a zero is purchased, the investor is promised a fixed rate of return for the life of security called the yield to maturity (YTM). If the investor holds the zero until maturity, the investor receives the maturity (face) value of $1000.
The difference between the discount price and the face value of $1000 is the return to the investor. The return is the interest earned on the principal invested compounded semiannually at the original interest rate (YTM). Bonds that are not zero-coupons have a fixed-coupon rate that pay periodic interest payments. Zeros do not have a fixed-coupon rate, hence the name zero-coupon, and do not make periodic interest payments to the holder. Instead of making regular interest payments, the value of the bond accrues each year by the interest rate (YTM) until the zero matures at face value providing the investor holds the bond until maturity. However, if a zero is sold before maturity, the investor could realize a gain or loss because the market price could be more or less than the purchase price plus the amount of interest (and the inflation adjustment to principal in the case of inflation-indexed notes and bonds) that has accrued between the time the security was purchased and the sale date. The current value of a zero before it matures will fluctuate according to fluctuations in the interest rate. The bond value is inversely related to interest rates. This means, as interest rates rise, the value of the bond will fall and as interest rates fall, the value of the bond will increase. However, if you hold the security until maturity, your return is backed by the full faith and credit of the U.S. Government. See the Present Value Chart for an example of how changes in interest rates reflect on the present value of a zero coupon bond. On the Present Value Chart, long-term zeros have lower market prices than short-term zeros, because long-term zeros accrue interest over a longer period of time. For example, assume that three zeros are quoted in the market at a yield of 6.50 percent. The price for zeros with 25 years remaining to maturity would be $202.07 per $1,000 face amount; the price for zeros with 10 years remaining to maturity would be $527.47 per $1,000 face amount, while that for 2-year zeros would be $879.91 per $1,000 face amount.
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