Difference Between a Zero Coupon CD & a Bond
Banks, governments and companies procure financing while providing investors with an opportunity to earn interest through what are known as debt securities. Debt security is an umbrella term that includes bonds and certificates of deposit or CDs, among others. Both bonds and CDs are conservative, though viable, investments that differ primarily in the manner by which they pay accrued interest. Bonds typically pay interest to the holder on a periodic basis through maturity, while CDs pay the entirety of accrued interest upon maturity.
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Bonds
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A bond is a debt instrument which offers the holder interest in return for a sum of money surrendered to the issuer as a loan. This sum of money, called the par value, serves as the basis for the accrual of interest. Having a life of one year or more, a bond pays the holder interim interest, or coupon, payments at regular intervals through maturity, unless otherwise specified. Upon the bond's maturity date, the holder receives the final coupon interest payment accompanied by the entirety of the bond's par value.
CDs
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A CD (certificate of deposit), also known as a time deposit, certifies that a sum of money has been deposited into a special savings account with a commercial or investment bank until a specific date. Until this date arrives, no part of the deposited money may be withdrawn without the imposition of heavy penalties on the depositor. Once the date has passed, the original sum of money is returned to the depositor accompanied by the interest accrued from the time the initial deposit.
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Coupon Interest
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Coupon interest payments on a given bond are typically dispersed just before the end of each quarter, or three-month interval. Similar to the amortization of a loan, the amount of each coupon payment is determined by dividing the total interest accrued through maturity by the total number of payments over the life of the bond. For instance, if a bond with a par value of $1,000 and a term of one year accrues interest at 10 percent per year; the total interest accrued at maturity would be $100 divided into four coupon payments of $25 each. The final payment totaling $1,025 includes the repayment of principal.
Advantages
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The coupon interest payments common to bonds make them an ideal investment for those looking to secure regularly occurring income payments with a relatively low level of risk. In addition, with a normal par value of $1,000, bonds are a realistic option for investors who have prudently saved money and wish to grow it or generate some supplemental income.
CDs are a more suitable option for large investors as they generally require the deposit of $100,000 or more. Though the terms of CD require that such a large sum of money be unavailable for several months or even years, the large single payment of interest received at maturity can provide a vehicle for a long-term financial goal or retirement savings.
Risks
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As a loan, a bond is only as creditworthy as the issuing entity, be it a company or a government. To this extent, all bonds carry what is called default risk: the risk that the bond's issuer will be unable to repay the interest and or principal in its entirety. Bonds also carry interest rate risk, which is the risk that a bond will lose its market value as a result of an overall rise in the level of interest rates.
Similar to bonds, CDs carry default risk, but only to the extent that the bank with which the money is deposited fails. From the point of view of the investor, there is the risk that he or she may require the deposited money and be unable to obtain it without paying significant penalties for early withdrawal.
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References
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