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Peculiarities of Zero Coupon Securities
Zero coupon securities are one type of investment that has some twists. Zero coupon securities are commonly called zeros, and they are different from other securities based on debt obligations. Zero coupon securities do not pay interest on the security, like other bonds and securities do. Instead these investments are offered at rates far below their face value, and the interest is accumulated and then compounded. Zero coupon securities are attractive to investors because they frequently have very good yields, and most investors hold these securities until they mature. This does not mean that these securities are without risk, or will yield an attractive amount every time, but their track record is pretty good. At maturity of the bond, the face amount of the bond is paid plus all of the interest that has accrued.
Zero coupon securities offer benefits, and there are a few big ones that make these securities in high demand. These securities are purchased at a cost that is very low when considering the face value and yield for the security, making them an investment that has the potential to offer better returns than many others. The second benefit of zero coupon securities is that the yield up to the maturity of the security has been locked in place, so there is no need to worry about the reinvestment of the interest. The interest on zero coupon securities is compounded, so even though you do not receive interest payments before maturity of the security, you will benefit from them. Compounded interest can grow much faster than straight interest, and this can leave investors with a bigger return on their investment when the zero coupon securities mature.
There are some disadvantages of zero coupon securities as well. One peculiarity about these securities is that even though the investor does not receive any interest payments until the securities mature, taxes are due each year on the interest accrued. This means that the taxes owed on the investment must be paid before the investor receives any interest payment, so the funds for these payments must come from another source of income instead. Another disadvantage of zero coupon securities is that the market value of the securities can be very volatile, with wide swings. The maturity value of the zero coupon securities can be brought down by inflation as well.
There are many different types of zero coupon securities, including securities issued by corporations and businesses, the federal government, municipalities, and other entities. Zero coupon securities have many differences from most other securities, and some of these differences can seem very peculiar to investors. These securities pay no interest, instead they are purchased for less than the face value. The interest is paid as the appreciated face value when it matures. Zero coupon securities are different in another way as well, because the investor must pay taxes on the interest payments that are not received. The IRS rules state that the taxes due on the interest must be paid even though the investor does not receive the interest in that tax year. This is called imputed interest. For this reason, many investors use zero coupon securities for portfolios that are already tax sheltered, such as retirement accounts. Zero coupon securities seem like the reverse of other securities. Instead of paying interest like most securities, zeros are bought lower and redeemed at an appreciated value, and the interest that is compounded with zero coupon securities is taxed before it is even received. That makes these securities unusual and peculiar, but they still offer a great investment opportunity.
The information supplied in this article is not to be considered as medical advice and is for educational purposes only.
|Securities Investment5 Dec 2008|
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