Both bonds and zero coupon certificates of deposit, or CDs, are debt securities, meaning the issuer of the bond or zero coupon CD promises to repay the investor the principal sum in addition to interest at maturity. Companies -- and governments -- issue bonds to raise capital. Banks and other lending institutions offer zero coupon CDs to investors willing to commit -- or lock in -- the deposit for a specific period in return for a higher rate of interest than a regular savings account provides.
According to the terms of a given bond, the issuer -- the entity borrowing money from the investor -- agrees to make regular interest payments to the bondholder and to repay the principal when the bond matures. With a CD, the investor deposits his money for a fixed period with a bank or other institution. A zero coupon CD is a specific CD type that's sold at a discount, with all accrued interest payable as a lump sum when the CD is redeemable by the investor.
A zero coupon CD is generally considered a more secure investment than a bond, because it is issued by large banks and credit institutions, which are considered more financially secure than private companies. The investor's deposit in the CD is also guaranteed by the Federal Deposit Insurance Corporation, or FDIC, up to $250,000, as long as the issuing institution is an FDIC member. A bond is only as secure as the company or governmental entity that issues it. Although the company or government entity is legally bound to repay the bond and the interest, this may be impossible if the issuer goes bankrupt or is liquidated. The risk associated with the bond will naturally depend on the stability of the company issuing it.
Differences: Interest Repayments and Return on Investment
The repayment of interest on a bond will depend on the terms set out in the bond agreement itself, but they're usually paid out periodically -- such as once or twice a year. With a zero coupon CD, interest is paid out with the principal as a lump sum at the end of the fixed period. Bonds often yield a higher rate of interest than zero coupon CDs to reflect the increased risk associated with this form of investment.
Although interest on a zero coupon CD isn't paid until the fixed period expires, tax on the interest accrued must be paid annually, as if the interest had been paid out to the account holder. Income generated by bonds is also taxed at the bondholder's regular rate. An investor looking for a safe, long-term way to save money with a solid return might favor a zero coupon CD over a bond. But if regular interest repayments and the opportunity to publicly trade the security are important to the investor, and she doesn't mind exposing herself to greater risk, she might prefer investing in bonds.
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