A:

Zero coupon bonds are volatile because they do not pay any periodic interest during the life of the bond. Upon maturity, a zero coupon bondholder receives the face value of the bond. Thus, the only value in zero coupon bonds is the closer to maturity, the more the bond is worth. Further, there is limited liquidity for zero coupon bonds since their price is not impacted by interest rate changes. This makes their value even more volatile. Zero coupon bonds are issued at a discount to par value. Yields on zero coupon bonds are a function of the purchase price, the par value and the time remaining until maturity.

Zero coupon bonds lock in the bond’s yield which may be attractive to some investors. Still, zero coupon bonds have unique tax implications that investors should understand before investing in them. Even though no periodic interest payment is made on a zero coupon bond, the annual accumulated return is considered to be income, which is taxed as interest. The bond is assumed to gain value as it approaches maturity. The gain in value is not taxed at the capital gains rate but is treated as income. Taxes must be paid on these bonds annually even though the investor does not receive any money until the bond maturity date. This may be burdensome for some investors. However, there are some ways to limit these tax consequences.

The easiest way investors can defer the taxes on a zero coupon bond is by holding them in a 401(k) or an IRA. The tax is only paid once the holder retires and takes money out of the retirement account. Those seeking to invest to pay education expenses for their children can place the bond in a child's name to avoid most taxes.

Another method of limiting taxes is to invest in zero coupon municipal bonds. Municipal bonds are issued by governmental entities, often to fund capital improvement projects. Many municipal bonds are exempt from the payment of taxes. Municipal bonds are generally considered safe investments, but there are still some significant risks. Government entities that issue bonds may have credit risk if they cannot meet their obligations under the terms of the bonds. Credit agencies provide credit ratings for municipal bonds; this may help investors determine which bonds are good for investing. While defaults on municipal bonds are generally rare, there have been some high-profile defaults since the 2008 financial crisis. The city of Detroit’s bankruptcy is a major example. Even where there are municipal defaults, investors have been able to recover around 60% of the debt value.

Municipal bonds may also have embedded call options in them which can increase risk. If interest rates go down, the bond issuer may decide to pay off the outstanding obligations. It then reissues bonds at the lower interest rate, thus decreasing the cost of capital. The investors may get a premium for the called bond but are likely forced to reinvest in bonds with a lower interest rate, thus reducing their yields.

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