Here is a helpful insight. You can grow money even when you get no regular interest. That is the simple power of zero coupon bonds. They do not pay periodic coupons. Instead they are sold at a big discount and repay full face value at maturity. The gap between the low price today and the higher amount you receive later is your return. This clear structure makes them easy to understand for many first time buyers of bonds.
What are zero coupon bonds
Zero coupon bonds are a type of bonds that do not pay interest during the life of the bond. You buy them below face value. On maturity you receive the full face value in one payment. The difference is your total gain. There are no interim cash flows to track or reinvest. That is why many people like the clean design of these bonds.
How do they work
Say the face value is 1000. You buy at 700. After a set number of years you get 1000. Your profit is 300 before tax. The longer the time to maturity the larger the usual discount. Market interest rates also affect the price. If rates rise prices fall and the discount gets bigger. If rates fall prices rise and the discount gets smaller. This link with interest rates is the same as for other bonds.
Key features you should know
There are no periodic coupons. All value comes at the end. Pricing is transparent because you can compare the discount against time left. Price can move more when maturity is far away. That is called higher duration risk in bonds. Many zero coupon issues are available in different tenors so you can match the maturity to your goal date.
Why investors choose them
They are simple to plan. You know the exact amount you will receive on a given date if the issuer pays on time. There is no need to worry about where to park coupon money. For goals like education or a milestone purchase you can pick a maturity that matches the date. This goal based approach is a common use case in bonds.
Risks to keep in mind
Price can be sensitive to interest rate changes especially for long maturities. If you sell before maturity you may face a gain or a loss. Credit risk still exists because the issuer must pay the full amount at the end. Always check the credit rating. Higher rating means lower default risk in most cases. Liquidity can vary for different bonds so do not assume an easy exit.
Who should consider them
If you want a fixed target amount on a future date these bonds are a neat fit. If you prefer regular income they are not ideal. They also suit investors who do not want the task of reinvesting coupons. Many retirees however may still prefer coupon paying bonds for steady cash flow.
A quick thumb rule
Longer time and higher discount usually mean a higher return. Shorter time and smaller discount usually mean a lower return. Still compare across issuers because credit quality and liquidity matter a lot in bonds.
Final word
Zero coupon bonds keep things straightforward. You pay a low price today and you get a known amount later. Understand the issuer the rating the time left and the market rate backdrop. With these checks you can use these bonds to hit clear money goals with less noise.
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