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Taxable Bonds

Zero-Coupon Bonds

Zero-coupon bonds are issued at a discount to face value and gradually accrue value to maturity. Zero-coupon bonds do not pay regular interest payments and mature at par ($1,000) for one lump sum payment. Corporations, municipalities, and the US Treasury issue zero-coupon bonds. Even though investors do not receive interest payments, the IRS requires owners of zero-coupon bonds to pay taxes each year. The tax comes from imputed interest accrued each year as the discount bond appreciates toward par. For example, a 10-year zero-coupon bond priced at $700 will appreciate $300 over ten years, amounting to $30 of taxable imputed interest per year. This does not apply to tax-exempt securities such as municipal bonds. In the secondary market the bond price is volatile because zero-coupon bonds have a locked in rate of return and no regular coupon payments to hedge against interest rate fluctuations. As interest rates rise, zero-coupon bonds tend to fall dramatically; however, when interest rates fall, zero bonds become more attractive and tend to appreciate in value dramatically. Zero-coupon bonds have an advantage because they are not subject to reinvestment risk. For instance, when investing in a 10-year zero, an investor locks in a fixed rate of return which can be expected to appreciate, to par, at a compounded annual return at maturity.