A UNIQUE DISCOUNT BOND

There is another type of bond you should know about.  You can buy it for a very substantial discount, but it does not pay interest on a regular basis.  It is called a zero coupon bond.

Why would you buy a bond that does not pay regular interest?  Because you can purchase it well below its face value.  A zero coupon bond is purchased at discount and redeemed for its full face value at maturity.  The issue price of a zero coupon bond is calculated as the present value of the par amount discounted at the coupon rate for the maturity of the bond.  For example, a twenty-year bond with an 8 percent coupon maturing at $1,000 would be worth $215 today.  The closer a zero is to its maturity, the more it is worth.

Zeros are more susceptible to interest rate changes than regular bonds are.  Their market prices are more likely to rise when interest rates fall.  Conversely, their prices fall more when interest rates go up.  For investors intending to hold onto zeros until maturity, their high volatility is not an issue.

One advantage of zeros is their significantly lower purchase price as compared to traditional coupon-paying bonds. Another advantage of zeros is the reliability of their return, because they have no reinvestment risk.  This is the risk that an investor will have to reinvest his or her annual interest payments at lower interest rates. Your total return with zeros will always equal the difference between what you paid for the bond and its par.

How are discount and premium bonds taxed?  You will find out in the next section.