4 Reasons to Avoid Zero-Coupon Bonds

Zero coupon bonds provide investors with a way to buy bonds at a large discount and then cash them in for the full face value of the bond later on. Even though this type of bond does have a few advantages, there are several reasons that you should avoid this type of investment. 

1. Cannot Reinvest Interest Payments

One of the big advantages of investing in traditional bonds is that they pay regular interest payments over the life of the bond term. Many investors will take the interest payments that are received from the bonds and reinvest them into other investments. They could potentially buy more bonds with the interest payments or even purchase shares of stock. This allows the investor to compound his or her returns and grow a portfolio quickly. When you are investing in a zero coupon bond, this is not going to be a possibility. The company is going to keep all of your money for you and then pay you the full value of the bond in several years. This limits your opportunities and your overall returns.

2. Low Returns

Even though it may seem like a good idea to invest in this type of bond, it is usually going to provide you with a low interest rate. If you agree to invest in this type of bond, you are going to be locking yourself into specific interest rate for the life of the bond. In many cases, inflation is going to eat up a large portion of the interest rate that is paid to you. For example, if you earned five percent annually on your zero coupon bond and inflation was three percent, you would only truly be earning two percent. 

3. Tax Issues

Investing in zero coupon bonds can be an issue because he have to pay taxes on the amount of money that you earn. With zero coupon bonds, you are not actually going to be paid any of the interest that is accruing. Instead, the company hangs onto it and uses it how they see fit. With this type of bond, you will receive a statement every year that tells you how much you have earned. According to the IRS, you are earning this money so you have to pay taxes on it. This means that you will have to come up with money from some other source to pay for the taxes on the interest that you earned.

4. Interest Rate Risk

This type of investment is subject to interest rate risk. If you are thinking about selling your bond on the secondary market at some point in the future, this could cause problems for you. If interest rates in the market increase above what the interest rate for your bond is, you are going to have to sell the bond for a discount. This limits the amount of flexibility that you have with this type of investment.

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