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These bonds are different from other types of bonds because no interest is paid out to the investor. Instead the interest stays in the bond and earns further interest at the same coupon rate. For instance, you buy a zero coupon bond with a coupon rate of 9 percent, every time the bond pays you interest, it is reinvested at the same rate of nine percent instead of coming to you. With a zero coupon bond, you know the interest you will get and what will the amount you will receive at the end of the bond term.
Zero coupon bonds are excellent way for saving money if you know that you will be needing money after a certain number of years. For example, if you want to buy a new car in 6 years or you want to make the final balloon payment on a mortgage, zero coupon bonds are an excellent investment instruments.
You can buy zero coupon bonds on a regular basis either once or twice a year so that you will have a steady income as each bond matures in the future. However, you have to be careful as the interest of zero coupon bonds is taxable and you have to pay taxes on the interest even if it does not come to you.
There are tax deferred zero coupon bonds like municipal zero coupon bonds and the interest from these bonds is tax exempt from the federal income tax. You can buy these bonds in your state to avoid paying state income states too. Although the yield is lower than any other bond but you will get tax benefits, and if you are in a higher tax bracket, it could work out to your advantage.
One of the zero coupon bond secret is to get an insurance since no interest is being paid to you. If the bond defaults, you will receive nothing unless you have an insurance.
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