Zero coupon bonds are traded on recognized financial markets and exchanges, which may offer investors liquidity in the event they choose not to hold them to maturity. One of the biggest risks of zero coupon bonds is their sensitivity to swings in interest rates. In a rising interest rate environment, their value is likely to fall more than other bonds. For individuals, zero coupon bonds may serve several investment purposes. By placing funds in a U. Treasury zero, a parent can be assured that the funds will be fully intact to meet this liability.
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Do you know how long it may take for your investments to double in value? Zero-coupon bonds are sold at a substantial discount from the face value. Zero-coupon municipal bonds combine the benefits of the zero- coupon debt instrument with those of tax-exempt municipal securities. Because the interest paid by zero-coupon municipal bonds is exempt from federal income taxes, these bonds provide returns that are often higher on an after-tax basis than comparable taxable securities. Further, tax-exempt zero-coupon municipal bonds earn interest that, in many cases, is also free from state and local taxes.
Certain out-of-state municipal bonds may be taxable at the state level.
- The ABCs of Zero Coupon Bonds | Asterion Wealth Advisory Group.
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- The ABCs of Zero Coupon Bonds | Summit Financial Solutions;
Check with a tax or financial professional. In contrast, taxable zero-coupon bonds like corporate bonds are taxed each year on the amount of interest that has accrued for that year unless held in a tax-deferred account , even though the accrued interest is not paid to investors in that year.
If an investor sells a zero-coupon municipal bond at a price that is higher or lower than the price at which it was purchased plus accrued interest, that investor might incur a capital gain or loss, as with any other fixed income investment. Be aware that a capital gain or loss may trigger additional tax implications.
Zero-coupon municipal bonds provide investors with the opportunity to lock in a specified rate of return, without having to worry about reinvestment risk or future interest rate changes. By contrast, investors in securities that pay interest semiannually may not always achieve a total realized compounded yield equal to the quoted yield to maturity they expected when they purchased their holdings. Depending on future prevailing interest rates, their interest payments may be reinvested in lower or higher yielding vehicles.
Zero-coupon municipal bonds offer a wide choice of maturity horizons, which can be helpful to investors with different investing goals. There are zero-coupon municipal bonds available with maturities ranging from one to 40 years, with the majority of these bonds having maturities between eight and 20 years. Some zero-coupon municipal bonds carry insurance to guarantee the payment on the bonds. Such a guarantee is based on the claims paying ability of the insurance company.
Keep in mind that credit ratings are only one factor to consider when assessing a bond investment and should not be the sole basis for any investment decision. If you decide to sell your zero-coupon bonds before they mature, you may do so in the secondary market at prevailing market prices refer to Market Risk. These bonds are sold as zero-coupon municipal bonds and then, generally after eight to 15 years, convert to interest-paying bonds.
The cash flow of the coupons is repackaged into stripped municipals with a greater variety of maturities from six months to 40 years. Like other zero-coupon bonds, stripped municipals are issued at a deep discount from face value and are available with a wide range of credit ratings. For municipal bonds of any kind, credit risk is determined by the financial and operating stability of the state or local government entity that issued the bond or the entity that is obligated to pay the principal of and interest on the bonds. You should assess the creditworthiness of a zero-coupon municipal bond the same way you would assess any municipal bond.
The rating agencies grade bonds according to their investment qualities, but do not intend the rating to be the sole basis for an investment decision.
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Before purchasing any bonds, particularly those with lower ratings, talk with a financial professional to make sure the bonds are appropriate for your investment goals. Some municipal bonds are backed by municipal bond insurance specifically designed to reduce investment risk. In the event of payment default by the issuer, an insurance company — which guarantees payment — will send you both interest and principal when they are due. As stated earlier in this guide, such a guarantee is based on the claims paying ability of the insurance company.
As with all fixed-income securities, the price of zero-coupon municipal bonds fluctuates, usually in response to changes in market rates. While the interest on a bond is fixed by the price you paid, newer bond issues may be offered at higher or lower interest rates, depending on prevailing interest rates when they were issued. Like other bonds, the values of zero-coupon municipal bonds move inversely to the movement of interest rates.
That is, bond values increase as interest rates decline, and bond values decrease as interest rates increase. As a result, zero-coupon municipal bonds that were purchased when interest rates were higher and sold in the secondary market when interest rates are lower will generate capital gains.
Conversely, investors who sell their bonds during periods of rising interest rates will incur capital losses. Many municipal bond issues allow the issuer to call or redeem all or a portion of the bonds at a premium or at par before the bonds matures.
Know the tax treatment of gains on bonds before investing
An issuer may choose to call a bond issue when interest rates decline, for example, in order to refinance the bonds at a lower rate. When investors purchase bonds, dealers will quote the yield to the call date if it is less than the yield to maturity. Therefore, an investor can know what the return on the bond will be if the issuer exercises its right to call the bonds.
Typically, zero-coupon municipal bonds containing call provisions provide that the bonds may be called at the option of the issuer on a specific date at a price or premium based on the accreted value of the security that was established at the time of issuance known as the original accretion rate. Before investing in any bond, pay careful attention to the call provisions.
Investor’s Guide to Zero-Coupon Municipal Bonds | Project Invested
Zero-coupon municipal bonds offer certain tax features that can be attractive to investors seeking long-term capital accumulation for retirement, education funding or other long-range savings goals. Individuals can time the maturity of their investment to match their future needs, which may include:. The table that begins on the following page will help you determine the yield you require from a taxable investment to equal the yield on a tax-exempt bond.
The table is for illustrative purposes only and is not intended to represent a specific security. To use the table most effectively, follow the directions under the chart. You may also look online for yield calculators that can help you determine bond yields. Note: SIFMA does not provide tax advice, and this is not intended to be a substitute for a consultation with a tax professional who knows the characteristics of the bond and your tax circumstances.
You should always consult with a tax professional when considering an investment in fixed income securities, such as zero-coupon municipal bonds. Determine your tax bracket by locating the taxable income category that you fall into. Taxable income is income after appropriate exemptions and deductions are taken.