Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market.
Zero Coupon Municipal Bonds: Tax Treatment - TheStreet
In addition, although no payments are made on zero coupon bonds until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying tax on the imputed interest by buying municipal zero coupon bonds if they live in the state where the bond was issued or purchasing the few corporate zero coupon bonds that have tax-exempt status.
The Securities Industry and Financial Markets Association has more information about zero coupon bonds on its website.
Search SEC. Is the effective rate method the only acceptable technique that can be used to compute and report interest when the face value of a debt differs from its issue price? Answer: Interest can also be calculated for reporting purposes by a simpler approach known as the straight-line method.
How Do I Calculate Yield To Maturity Of A Zero Coupon Bond?
Using this technique, an equal amount of the discount is assigned to interest each period over the life of the bond. Payment will be made in two years. However, a question should be raised as to whether the information reported under this method is a fairly presented portrait of the events that took place.
Although the bond was sold to earn 6 percent annual interest, this rate is not reported for either period.
In reality, the parties established an annual rate of 6 percent for the entire two-year period. When applying the straight-line method, this actual rate is not shown for either year. Furthermore, the reported interest rate appears to float 6. That did not happen; there was a single 6 percent interest rate agreed-upon by the debtor and the creditor.
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The straight-line method does not reflect the reality of the transaction. However, it can still be applied according to U. GAAP but only if the reported results are not materially different from those derived using the effective rate method.
What are Zero Coupon Bonds?
Zero-coupon bonds pay no cash interest. They are sold at a discount to provide interest to the buyer. The price of the bond is determined by computing the present value of the required cash flows using the effective interest rate negotiated by the two parties. Present value represents the principal of the debt with all future interest mathematically removed. The bond is recorded at this principal. Interest is subsequently determined each period based on the effective rate.
Because no cash interest is paid, the entire amount recognized as interest must be compounded added to the principal. The straight-line method can also be used to record interest if the resulting numbers are not materially different from the effective rate method. Previous Section.
Glossary of Municipal Securities Terms
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Explain how interest is earned on a zero-coupon bond. Understand the method of arriving at an effective interest rate for a bond. Calculate the price of a zero-coupon bond and list the variables that affect this computation. Prepare journal entries for a zero-coupon bond using the effective rate method. Key Takeaway Zero-coupon bonds pay no cash interest.
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Already answered Not a question Bad question Other. Warnings Make sure that the required rate of return and the number of time periods remaining until maturity are measured in the same units of time. In the above example, the stated interest rate was an annual one, and the number of time periods until maturity was measured in years.
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Zero Coupon Bond Definition