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1 Zero Coupon Bonds

Zero coupon bonds pay no coupon interest and provide only one cash flow: payment of their par value upon maturity. Treasury bills are a form of zero coupon debt. An investor purchases a T-bill at a price below par and receives no interest or other cash flows until maturity. At that time, the investor receives the par value of the T-bill. The return on the security is the difference between its discount price and its par value.

The primary reason for the popularity of zero coupon bonds is that investors do not face any reinvestment rate risk. As these bonds provide no cash flows to reinvest, investors effectively lock in a given yield to maturity. However, under IRS regulations, investors must pay yearly taxes on the implicitinterest paid by the bonds; the IRS has special rules for determining this value. In essence, investors must pay taxes on income they have not received. Thus, zero coupon bonds are mainly purchased by tax-exempt investors who pay no tax on...