The Pros and Cons of Zero-Coupon Bonds

Zero-coupon bonds are a type of bond that does not pay any regular interest payments to the investor. Instead, you purchase the bond for a discount and then when it matures, you can get back the face value of the bond. This is a long-term type of investment that can provide nice yields. Here are some of the pros and cons of investing in zero-coupon bonds.

Pros

One of the big advantages of zero coupon bonds is that they have higher interest rates than other corporate bonds. In order to attract investors to this type of long-term proposition, companies have to be willing to pay higher interest rates. This means that if you are alright with not receiving regular interest payments, you can actually make more money in the long run with zero coupon bonds.

This type of investment is also great for investors who have long-term specific objectives in mind. This type of bond gives you the assurance that you will know exactly how much it will be worth at a specific date in the future. Therefore, if you are trying to save for a specific objective, this can be a nice investment. For example, if you are trying to save money for a child's college tuition and you do not feel comfortable putting that money into the stock market or a mutual fund, a zero-coupon bond will allow you to know exactly how much to expect. This makes it possible for you to know that you will have enough for your child's tuition in the future.

Cons

One of the biggest problems with investing in zero coupon bonds is that you have to pay taxes on phantom interest. This means that you will need to pay income taxes on interest that you are not actually receiving. Even though you are not physically receiving any interest payments from the bond issuer, according to the federal government, you are still earning this money. This means that you have to pay income taxes on that interest in the year in which it was earned. While this will be nice when the bond matures and you do not have to pay any taxes on the money, it can be a hassle leading up to that point. Many people do not want to have to come up with money from another source in order to pay taxes on the interest from this type of bond.

Another problem with zero coupon bonds is that they have a higher default risk than traditional bonds. The reason behind this is that companies do not have to make regular interest payments to the investors. They just keep all of the money and do with it as they please. If they do not make the proper arrangements to pay off the debt in the future, they could go into default.

In some cases, these bonds can be called by the companies that issued them. This means that they will pay back the amount that you invested with the interest that you have earned but it will not last for the entire term.

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