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Zero coupon bonds are bond issues that work in a manner that is very different from the usual interest-bearing bond. Rather than offering periodic interest payments for the duration of the bond, zero coupon bonds are purchased at less than the face value and are not redeemable until the date of maturity is reached. In spite of this different approach, there are actually a few reasons why a zero coupon bond might be an ideal investment.
Sometimes referred to as a no coupon bond, the idea behind a zero-coupon bond is to provide the option of purchasing bonds at a price that is less than the face value of the bond. In return for paying this reduced rate up front, the bond holder is offered a rate of interest that will eventually yield a return that is equal to at least the face value, and possibly a little more. Considered to be one of the safest types of bond issues, zero coupon bonds are an excellent way to raise money for financing a project that is expected to produce profits well before the maturity date of the bonds arrive.
It is important to note that the interest on zero coupon bonds is not paid to the bondholder incrementally. Instead, the interest is calculated on a recurring basis. Generally, the interest is compounded on an annual or semi-annual basis, with the rate of interest added to the no coupons account. This process continues until the zero coupon bonds reach maturity. At that point, the bondholder receives the initial purchase price of the bond, plus all the interest accrued over the life of the bond.
In some instances, there is no interest involved at all with zero coupon bonds. It is possible to offer a bond at a price that is discounted from the face value. In return, the bondholder will collect an amount that is equal to the face value of the bond at the point of maturity. Some investors prefer this arrangement to the discounted acquisition plus cumulative interest, since the redemption at full face value makes it possible in advance to know exactly what the return on the investment will ultimately equal.