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Finance Glossary

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Zero Coupon Bonds

Definition:

Bonds that do not have any stated coupon rate are called zero-coupon bonds. Instead of paying regular interest, these bonds are issued at a large discount to their face value, and pay the face value at maturity. The difference between the issue price and face value represents the interest earned on the bond.

Example

Why would you want a bond like this? Well, they usually pay more. Why? There's usually more perceived risk in a Zero, in that you get NONE of your money back until the very end.

In a normal "vanilla" bond, you at least get the semi-annual interest payments along the way so if the company goes bust and really can't pay you back for your sweat, toil, and savings you invested, then at least you got the interest. And that interest can mean a lot to retirees and others who need the cash to live on (so many of them don't buy Zeros in the first place).

But Zeros are great if you already have lots of cash as they are "illiquid." Until they are very liquid—meaning that when they come due, say, on a given issue, 10 years later, you get a mountain of cash. To wit, if you bought a bond maturing for $1,000 in 10 years, that had a face value of 6% yield, you'd put down today $558...and get almost double your money back in a decade. 

All from our hero, Zero.

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