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Investing in Zero-Coupon Bonds
When you purchase a bond issued by a corporation or government, you are lending the issuer money. Typically you can expect to earn a specific rate of interest, or yield, on your loan and receive regular payments, often on a semiannual basis.
You also can expect the principal, or face value, of the bond to be paid back to you at the end of the period you have agreed to lend your money, which is the bond’s maturity date.
But the process is different when you invest in securities known as zero-coupon bonds.
What’s a zero-coupon bond?
Zero-coupon bond funds
Annual taxes on accrued interest
What’s a zero-coupon bond?
U.S. Treasury zero-coupon bonds are securities that:
- are sold at a deep discount from their face value.
- do not pay interest.
The return on a zero-coupon bond comes from the difference between the purchase price of the bond and its value at its maturity date.
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Zero-coupon bond funds
Zero-coupon bond funds invest in individual zero-coupon bonds. This type of fund can provide a relatively dependable return if held to maturity. Prior to maturity, a zero-coupon bond fund may have dramatic share price fluctuation in response to changing interest rates. Shares sold before maturity may produce significant losses or gains.
Some investors prefer zero-coupon bond funds to save for specific goals, such as retirement or a child’s college education, because they can estimate in advance approximately how much these investments will be worth when they mature. However, there is no guarantee the fund shares will reach their anticipated value at maturity.
For example, if you had $10,000 to invest for a particular goal in the year 2025, you might allocate around $3,000 to zero-coupon bonds with a face value of $10,000 at maturity. You could invest the remaining $7,000 in a stock fund or other securities.
No matter what happened to your other investments, your initial investment of $10,000 would be returned when the zero-coupon bonds matured.
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Annual taxes on accrued interest
Although you do not receive regular interest payments from zero-coupon bonds, the IRS requires you to pay income tax on the accrued interest each year as if it had been paid to you. This type of interest is referred to as “imputed interest.”
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Bonds and bond funds can help you create a diversified portfolio of investments to reach your goals. Analyze your asset allocation and learn more about the ways bonds can fit in your investment plan.
This information is for educational purposes only and is not intended as investment advice.
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