However, in contrast, an investor who owns a regular bond receives income from periodic coupon payments, which are usually made semi-annually. Some zero-coupon bonds do not start out as zero-coupon bonds. Because zero-coupon bonds do not pay interest and their par value is due at maturity, their price is more sensitive to interest rates.
Therefore, not only is a falling interest rate environment good for bonds, it is even better for zero-coupon bond funds. With regard to bond mutual funds, keep in mind that the investor owns shares of the mutual fund and not the holdings of the mutual fund portfolio. Therefore the bond mutual fund's price or what is referred to as its net asset value or NAV is a central function of the bond fund's total return to the investor.
This is why bond mutual funds have principal risk -- because the amount invested can fall in value, whereas an individual bond holder can simply hold their bond without incurring any loss, as long as they don't sell their bond at a lower price than purchase. Bond prices and interest rates are like two opposing ends of a teeter-totter: When one side rises, the other side falls. Therefore when interest rates are rising, bond prices are falling and when interest rates are falling, bond prices are rising.
The ABCs of Zero Coupon Bonds
So the best time to invest in bonds is when interest rates are falling because the price or value of your bond investment is rising. The only question that remains with regard to the best timing for investing in zero-coupon bond funds is: When are interest rates likely to fall? The answer is during deflationary times. The reason is that the Federal Reserve will fight deflation, which is a period of falling prices for consumer goods and services, by reducing interest rates through the purchase of Treasury Bonds.
Investors should use caution when buying and holding zero-coupon bond funds because their prices have dramatic swings up and down. Also, long-term bonds will have greater fluctuation in price than short-term bonds. For example, in the year , ZROZ had a Be sure a check what if any those provisions are before you invest. The major credit agencies rate most zero coupon bonds for credit worthiness. This rating can change during the life of the bond, which can affect the price.
Corporate zero coupon bonds carry the most risk of default and pay the highest yields. Many of these have call provisions.
As you can see, the farther out you go the lower your front-end cost and the more work compounding does to get you to the full face value. You buy zero coupon bonds a deep discount to face value. You receive no interest until maturity; however, in most cases, you do owe taxes annually on the interest as it accrues.
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By Ken Little. Here are some general characteristics of zero coupon bonds:. Of the three kinds of zero coupon bonds, U. Treasury bonds are the most popular. Municipal zero coupon bonds are free from federal income tax like regular municipal bonds.