Zero-Coupon Bonds are a type of debt securities that are purchased at a discounted price and redeemed at full face value upon maturity thereby providing profit for the investor. Unlike conventional Bonds that disburse regular coupon payments, Zero-Coupon Bonds make no interest payments. This type of Bond can be short or long-term, and held until maturity or sold on the secondary bond market.
An example of Zero-Coupon Bonds is Strip Bonds, also known as Separate Trading of Registered Interest and Principal Securities, which are often purchased by Investment banks or Dealers. The Bonds are then separated into coupon and principal amounts, creating a new supply of Zero-Coupon Bonds sold at a discount to investors.
One benefit of investing in Zero-Coupon Bonds is a guaranteed yield until maturity, as the investment compounds at a fixed rate with no need to reinvest interim coupons or interest payments. Additionally, Strip Bonds can be used to reduce the risk in options trading by avoiding incorrect wagers on declining stock prices.
However, Zero-Coupon Bonds have limitations when compared to other debt instruments. There is no opportunity to reinvest modest interest payments into higher yielding bonds. Holders of Zero-Coupon Bonds may also be subject to annual income tax on the profit or income that accrues each year.
Regardless of the type of bond desired, investors are advised to thoroughly research the market before making any investment decisions due to fluctuations in stock prices and value.