How Investors Make Money on Bonds

A coupon-paying bond is a type of bond that pays a fixed amount of interest, usually twice a year until the bond reaches maturity. On the other hand, a zero-coupon bond is purchased at a discount from its face value, and the investor receives the full face value when it matures. The interest paid on a bond can either be predetermined or based on the prevailing interest rates at the time of maturity.

Basics

Fixed-income securities, such as bonds, represent a category of investments. Functioning as debt obligations, these financial instruments involve an investor lending a specified principal amount to a government or company for a predetermined duration. In exchange, the investor receives a sequence of interest payments, constituting the yield. Upon maturity, the principal is repaid to the investor.

Generating Profit Through Coupon-Paying Bonds

Profits from bonds can be obtained through two primary ways:

• Individual investors may directly acquire bonds, intending to retain them until maturity to capitalize on accrued interest. Alternatively, they can invest in a bond mutual fund or a bond exchange-traded fund (ETF).
• Within the secondary market, professional bond traders play a pivotal role in buying and selling existing bonds, often at a discount to their face value. The degree of discount is influenced by the remaining payments until maturity and reflects a speculative stance on the trajectory of interest rates. Should a trader anticipate lower interest rates on new bond issuances, the value of existing bonds may rise.

In both scenarios, bond owners receive periodic interest payments, termed the coupon, based on the predetermined interest rate at the bond's issuance. For example, a $1,000 investment in a 10-year bond with a 4% coupon rate results in an annual coupon payment of $40, typically distributed semi-annually in two $20 installments.

Zero-Coupon Bonds: A Strategic Financial Approach

Zero-coupon bond investors await maturity for returns, as no periodic payments are made during the bond's lifespan. Acquired below face value, these bonds eventually yield the full face value upon maturity.

Zero-coupon bonds, also referred to as discount bonds, include notable examples like U.S. Treasury bills (T-bills) and U.S. savings bonds. In the secondary bond market, these bonds are traded at a discount influenced by outstanding payments and traders' interest rate predictions.

Most zero-coupon bonds feature predetermined face values, ensuring fixed payouts at maturity. Some, however, are inflation-indexed, determining face value at maturity based on indicators like the consumer price index plus a premium.

Diverse Maturities of Zero-Coupon Bonds

Zero-coupon bonds exhibit varying maturity dates:

• Short-term variants, often termed bills, mature in one year or less.
• Long-term zero-coupon bonds, considered extended investments, may have maturity dates spanning 10 to 15 years or beyond.

Coupon-Paying vs. Zero-Coupon Bonds

Investors, particularly older individuals, and retirees, often favor coupon-paying bonds for their steady income, valuing the safety of bond investments.

Short-term Treasury bills offer a similar appeal, serving as reliable income supplements and secure investment options. Conversely, long-term zero-coupon bonds may lack appeal for older investors unwilling to commit funds for extended periods. However, such bonds can be integral to a young family's savings strategy or employed by affluent investors for wealth transfer purposes.

Tax Advantages of U.S. Zero-Coupon Bonds

U.S.-issued zero-coupon bonds maintain an original issue discount (OID) for tax considerations. Despite their non-payment of periodic interest, zero-coupon bonds may trigger phantom income. To circumvent this, U.S. investors can hold such bonds in tax-deferred retirement accounts, ensuring future income remains untaxed. Additionally, suppose a zero-coupon bond is issued by a U.S. local or state government entity. In that case, the interest enjoys federal tax exemption and is generally free from state and local taxes.

Conclusion

The choice between coupon-paying and zero-coupon bonds depends on investor preferences, with the former providing steady income and the latter offering a lump-sum return at maturity. Both play essential roles in diversified portfolios. Profit strategies involve direct acquisition or investment in bond funds for coupon-paying bonds, while zero-coupon bonds with varying maturities cater to diverse investment strategies. U.S.-issued zero-coupon bonds offer tax advantages through the original issue discount, and holding them in tax-deferred retirement accounts mitigates phantom income, providing incentives for strategic financial planning.