Capital appreciation bonds, also known as zero coupon bonds, allow you to receive a large return in the future in exchange for a small investment now. Corporations, the U.S. Treasury and smaller government agencies issue these bonds to raise funds for long-term projects. Unlike conventional bonds, which make periodic interest and principal payments, zero coupon bonds make no repayments until the maturity date. Prices of capital appreciation bonds are more volatile than those of other forms of bonds because they are dependent on interest rate fluctuations. The bond price typically drops as interest rates rise.
The original purchase price of the bond is known as the principal. This represents the balance of the loan the company must pay back to the investor on the maturity date. The principal price is deeply discounted from the final payout at maturity. Using capital appreciation bonds lets a company raise capital for expansion by issuing more bonds than it can afford to pay back at the current time. When the bonds mature, the project should be producing sufficient income to cover the repayments.
The par value is the amount you receive if you hold a capital appreciation bond until its maturity date. The difference between a bond's par value and the original purchase price is your return on investment. You must pay a penalty if you sell your bond early. This may drop your overall ROI below zero if you have not held the bond long enough for it to appreciate significantly in value.
The interest on a capital appreciation bond compounds until the bond matures. No interest payments must be made, so the bond issuer can conserve its cash for expansion. The overall interest on a zero coupon bond is computed by subtracting the principal from the par value. To find the interest for a single year, divide the par value by the principal. Take the nth root of the result, where n equals the number of years in the bond's term. Subtract 1 from the result to find the interest rate.
Capital appreciation bonds offer longer terms than standard corporate or municipal bonds. These bonds typically mature after 10 to 20 years. This allows you to invest a small amount of money that will grow to a significant savings account over time. Zero coupon bonds work well for long-term goals, such as retirement planning or establishing a child's college fund.
You are required to pay taxes on the imputed interest each year even though you do not receive any payments. Municipal capital appreciation bonds are exempt from tax if you live in the same state as the issuer. You may also be able to invest in corporate tax-exempt bonds to avoid taxation on imputed income.
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