 Personal Finance PowerPoint Presentation. Zero coupon bond versus regular bond. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia. What is the difference between a zero coupon bond and a regular bond, which you can find online. Take a look at the references, resources, continue your research from there. This by Chad Landgager updated August 31, 2020 in prior presentations. We've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is the difference between a zero coupon bond and a regular bond? The difference between a regular bond and a zero coupon bond is the payment of interest, otherwise known as a coupon as coupons. So if we just think about bonds in general, note that if we are the investor, we're thinking from the perspective of the investor. Then we typically want the balance portfolio. So we might be investing some into equities into stocks, some into the fixed income into the bonds on the bond side of things. We could think of it in essence as a kind of loan, us loaning the money to the issuer of the bond. That being typically either the government or the a corporation. And usually then if you think about this and compare it to say when you take out a loan, say like a mortgage. Usually then you are if you're the one borrowing in the mortgage, you're paying back both interest and principal. Each time you make the payment, they try to even it out over the payments as you pay them back. And the case of a bond that's structured a little bit differently normally, right? Say we're going to give the money to the corporation or the issuer of the bond. The could be the government. And then we're going to be receiving in return instead of regular payments that include the principal, just the interest portion, just the rent portion. Often that normally would happen like in a semi annual or twice a year instead of monthly type of basis. And then at the termination of the bond, we would in essence receive the principal back. We can also buy the bond at a discount or a premium, for example. If you're talking about zero coupon bonds, then you have a situation where you're not getting the payments on a periodic basis, interest or principal. And instead, you're going to get the payment at the end, which will in essence account for the basically interest that has been accrued during that period. Because you will typically buy the bond basically at a premium. In other words, you're going to buy the bond for an amount less than the face amount or the amount that you're going to receive at maturity. In other words, the difference then is in essence interest when you receive at maturity. So a regular bond pays interest to bondholders while zero coupon bonds does not issue such interest payments. So you're not going to get those regular interest payments. Instead, zero coupon bondholders merely receive the face value of the bond when it reaches maturity. So again, you might say, well, why would I do that? Why would I loan money in essence, pay for something where I'm not going to get the regular interest payments? Because you're buying the bond at a premium and when you get the face amount, it'll typically be more than you paid for it. Therefore, you are in essence getting the interest, but you're getting it at the point in time when the maturity happens rather than getting the interest portion of it as regular payments over the term of the bond. So regular bonds, which are also called coupon bonds, pay interest over the life of the bond and also repay the principal at maturity. The difference for investors, long term zero coupon bond investors gain the difference between the price they pay for the bond and the amount they receive at the bond's maturity. So this amount can be substantial because zero coupon bonds are typically purchased at deep discounts to the bond's face value. And you can kind of compare this like if you were to take out a loan, for example, instead of the normal structure of the loan where you basically pay back the same amount each month, which includes an interest and principal component. You can imagine one where you just pay back the interest and then you give back the loan at the end or you can imagine a situation where you're going to say, I'm going to pay you the lump sum at the end, which includes the interest and basically the principal. That's kind of what's happening here on the bond side. We on the investing side of things, in essence, loaning money and we're promised to pay back the face amount. They're going to give back the face amount, but we're going to purchase it at something below the face amount. And the difference between the two, you know, is in essence interest that has accumulated over the time. So this discount frequently leads to higher returns in the long run. A zero coupon bond was usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. So obviously you're kind of taking on more risk and that you're not getting payments. You're not getting the income throughout the timeframe. You're getting paid all at one lump sum at the end. So you would expect that you would want a bigger return in order to buy those bonds as compared to bonds that were paying you periodically. So with a normal yield curve, long term bonds have higher yields than shorter term bonds. The interest payment made by regular coupon bonds are due before the date of maturity. So those payments are like small zero coupon bonds that mature earlier. Interest payments cut down the wait time and the risk. So they also reduce expected returns. The difference for speculators, zero coupon bonds are more volatile than coupon bonds. So speculators can use them to profit more from anticipated short term price movements. So again, if you're looking at it in terms of a long term investor, then again you're probably trying to get exposure to kind of bonds in general to balance out your portfolio. When we're talking about speculators, then we're talking more about people that are on possibly on the short term trading type of thing, trying to make money predicting the market, beating the market in essence basically on the short term looking for the short term kind of activity. So remember that you want to know where you stand in terms of what kind of investor you're aiming to be here. So all other things being equal, the price of a zero coupon bond will increase more than the price of a regular coupon bond when interest rates fall. Because US Treasury bond prices respond strongly to interest rate changes, zero coupon treasuries are preferred for speculating on interest rates. Zero coupon corporate bond prices are also volatile so they can be used for speculating on the health of the issuing company. Suppose that a company facing bankruptcy previously issued zero coupon bond and coupon bonds that both mature in five years. The market price of both bonds would have plummeted with the result that the coupon bonds now pay very high interest related to their purchase price. That creates a cushion if the company should go bankrupt before maturity. The zero coupon bond has no such cushion, faces higher risk and makes more money if the issuer survives. So zero coupon bonds and taxes, zero coupon bonds may also appeal to investors looking to pass on wealth to their heirs. If a bond selling for $2,000 is received as a gift, it only uses $2,000 of the yearly gift to exclude for gift tax exclusion. So note when you get into like estate planning and gift kind of planning, those things are kind of tied together. You're looking at the estate taxes which typically will be applicable to people that have larger income. So when someone, a wealthy person dies, we all know that the government rejoices, comes in and rolls the corpse over and starts going through the pockets and seeing if there's any diamonds that have been established in any cavities or anything like that. So that's what, so obviously then and then you know that the person that was doing estate planning might say, well, I'm just going to gift everything to my inheritance to my children or something like that before I die. So they don't take my money after I'm dead, but then the government didn't like that. So of course now you've got the gift, the gift tax, it's tied into the exclusion for the estate tax or the death tax. So now there's all this estate, you know, this tax planning for estate planning can get quite complex and using ways to maximize the amount of gifts that you can get to lower the level of the estate. So there's less taxation upon death of a wealthy individual. So that gets into a whole nother kind of topic. However, the recipient ultimately receives substantially more than $2,000 after the bond reaches maturity. Unfortunately, the zero coupon bond holder, some taxes can reduce the effectiveness of this strategy. So in the U.S., zero coupon bonds create a tax liability for interest payments even though they don't actually pay periodic interest. That creates a phantom income problem for the bondholders. So it can be challenging to come up with the money to pay taxes on income that was not received. So notice that if you were to look at the interest, like the income, you have kind of an accrual basis kind of concept and a cash basis type of concept. And if you have an income tax and you're saying, well, you earned the income, the income has accrued on it. If the tax code is saying, I want you to pay the tax on income when it is accrued, not necessarily when it's paid because you have earned it. And normally when we think about a loan, for example, the income is accruing interest accrues because there wouldn't be a loan if there wasn't income related to it on a market transaction, arms length transaction. But the problem with taxes and income tax is that if you charge income on income that has accrued, but you haven't received the cash, then if it's a substantial tax, you might not have the cash to actually pay the income tax because you haven't got the cash even though you recognize the income. So consequently, it is often a good idea to hold zero coupon bonds in a tax deferred retirement account to avoid paying taxes on future income. So that would be under like an IRA or 401K, possibly the most common kind of deferred tax accounts. A zero coupon bond issued by US local or state government entity is another alternative. The municipal interest on these municipal bonds, including input interest for zero coupon bonds, is free from US federal taxes. Municipal bonds are often free from state and local taxes as well.