20 Investments: Zero-Coupon Securities
  1. 20 Investments: Introduction
  2. 20 Investments: American Depository Receipt (ADR)
  3. 20 Investments: Annuity
  4. 20 Investments: Closed-End Investment Fund
  5. 20 Investments: Collectibles
  6. 20 Investments: Common Stock
  7. 20 Investments: Convertible Security
  8. 20 Investments: Corporate Bond
  9. 20 Investments: Futures Contract
  10. 20 Investments: Life Insurance
  11. 20 Investments: The Money Market
  12. 20 Investments: Mortgage-Backed Securities
  13. 20 Investments: Municipal Bonds
  14. 20 Investments: Mutual Funds
  15. 20 Investments: Options (Stocks)
  16. 20 Investments: Preferred Stock
  17. 20 Investments: Real Estate & Property
  18. 20 Investments: Real Estate Investment Trusts (REITs)
  19. 20 Investments: Treasuries
  20. 20 Investments: Unit Investment Trusts (UITs)
  21. 20 Investments: Zero-Coupon Securities
  22. 20 Investments: Conclusion

20 Investments: Zero-Coupon Securities

What Is It?
A zero-coupon security, or "stripped bond", is basically a regular coupon-paying bond without the coupons. The process of "stripping" or "zeroing" a bond is usually done by a brokerage or a bank. The bank or broker stripping the bonds then registers and trades these zeros as individual securities.

Once the bonds are stripped, there are two parts: the principal and the coupons. The interest payments are known as "coupons", and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are bundled and referred to as zero-coupon bonds or "zeros".

You can think of a zero-coupon security just like a T-bill. Basically, you pay a certain amount right now in exchange for the par value of the security at a future date, usually $1,000. For example, you might pay $800 for a zero-coupon bond today and in five years you will receive the par value of $1,000. The longer the time to maturity, the cheaper you can buy the bond for. This predictability also makes zeros popular - when you buy the security, the yield is essentially locked in.

Objectives and Risks
The basic objective of a zero-coupon security is "buy low, sell high". You purchase the bond for a sum of money, and once it reaches maturity you will be paid an even larger sum of money. When interest rates are low, the price of the zero will be higher. The best time to buy a zero is when interest rates are high because the bond will be at a deeper discount.

The one major problem with zeros is that the annual accumulated return is actually considered to be income, and while you don't actually collect that interest until the bond reaches maturity, you still have to pay income tax on it. In other words, the gains on a zero are not treated as capital gains, instead they are considered to be interest.

How To Buy or Sell It
Zero-coupon securities can be bought through most full service or discount brokers, commercial banks, and some other financial intermediaries.

Strengths

  • Zeros can be bought at huge discounts.
  • Once you buy a zero-coupon security, you essentially lock in the yield to maturity.

  • Weaknesses
  • If the company issuing the zero goes bankrupt or defaults, then you have everything to lose. Whereas, with a regular coupon bond, you may have at least gotten some interest payments out of the investment.
  • Interest earned on the zero-coupon bond is taxed as income (a higher rate) rather than capital gains.

  • Three Main Uses
  • Capital Appreciation
  • Tax-Deferred Savings
  • Predictability
  • 20 Investments: Conclusion

    1. 20 Investments: Introduction
    2. 20 Investments: American Depository Receipt (ADR)
    3. 20 Investments: Annuity
    4. 20 Investments: Closed-End Investment Fund
    5. 20 Investments: Collectibles
    6. 20 Investments: Common Stock
    7. 20 Investments: Convertible Security
    8. 20 Investments: Corporate Bond
    9. 20 Investments: Futures Contract
    10. 20 Investments: Life Insurance
    11. 20 Investments: The Money Market
    12. 20 Investments: Mortgage-Backed Securities
    13. 20 Investments: Municipal Bonds
    14. 20 Investments: Mutual Funds
    15. 20 Investments: Options (Stocks)
    16. 20 Investments: Preferred Stock
    17. 20 Investments: Real Estate & Property
    18. 20 Investments: Real Estate Investment Trusts (REITs)
    19. 20 Investments: Treasuries
    20. 20 Investments: Unit Investment Trusts (UITs)
    21. 20 Investments: Zero-Coupon Securities
    22. 20 Investments: Conclusion
    RELATED TERMS
    1. Coupon Stripping

      The separation of a bond's periodic interest payments from its ...
    2. Zero-Coupon Bond

      A debt security that doesn't pay interest (a coupon) but is traded ...
    3. Strip

      1. For bonds, the process of removing coupons from a bond and ...
    4. Zero-Coupon Convertible

      A fixed income instrument that is a combination of a zero-coupon ...
    5. Discount Bond

      A bond that is issued for less than its par (or face) value, ...
    6. Strip Bond

      A bond where both the principal and regular coupon payments--which ...
    RELATED FAQS
    1. What is the difference between a zero-coupon bond and a regular bond?

      The difference between a zero-coupon bond and a regular bond is that a zero-coupon bond does not pay coupons, or interest ... Read Answer >>
    2. How does an investor make money on a zero coupon bond?

      Learn about investing in zero-coupon bonds, exactly how they work as an investment vehicle, and their advantages and disadvantages ... Read Answer >>
    3. Why do zero coupon bonds tend to be volatile?

      Learn why the price of zero coupon bonds is volatile and why some investors may wish to hold them in retirement accounts ... Read Answer >>
    4. What is a stripped bond?

      The quick answer to this question is that a stripped bond is a bond that has had its main components broken up into a zero-coupon ... Read Answer >>
    5. How do debit spreads impact the trading of options?

      Find out what it means when a bond has a coupon rate of zero and how a bond's coupon rate and par value affect its selling ... Read Answer >>
    6. Why do interest rates tend to have an inverse relationship with bond prices?

      At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer ... Read Answer >>

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