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Chapter 19. Working with Bonds > Working with Zero-Coupon Bonds

Working with Zero-Coupon Bonds

A zero-coupon bond is one in which all the coupons have been “clipped” so that there are no interest payments. This might sound like a bad thing, but zeroes (as they're often called) are always sold at a deep discount from the face value, so the “interest” you earn is the difference between the discounted price and the face value you get at maturity. The big advantage of zeroes is that you have no reinvestment risk, which is the risk associated with reinvesting coupon payments with an ordinary bond. For example, if bond yields have gone down, your reinvested interest won't earn as much as you would like. That's not a problem with zeroes because there is no interest to reinvest: You simply watch the bond's value grow from the discounted price to the face value. (There are some downsides to zeroes: You must still pay taxes on the “income” you earn each year; zeroes are exceptionally volatile, so if you're forced to sell before maturity, it might be at a substantial loss; and the investment doesn't pay until maturity, so you run the risk of losing the entire investment if the issuer can't meet its obligations.)

Depending on how close the maturity date is, the yield on a zero-coupon bond is generated by purchasing the bond at a deep discount from the face value. For example, a zero-coupon bond that doesn't mature for another 20 years might sell for as little as $30 per $100 face value.


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