SIE practice questionmediumZero-Coupon Bonds
An investor purchases a zero-coupon bond. Which of the following is TRUE?
- AThe investor receives all interest at the time of purchase
- BThe bond is purchased at a discount and the investor must pay taxes annually on imputed (phantom) interest✓ Correct answer
- CThe investor receives semiannual interest payments
- DZero-coupon bonds have less interest rate risk than comparable coupon-bearing bonds
Explanation
Why B — The bond is purchased at a discount and the investor must pay taxes annually on imputed (phantom) interest
Zero-coupon bonds pay no periodic interest — they are purchased at a deep discount and mature at par. However, the IRS requires holders to pay taxes annually on the imputed (accreted) interest even though no cash is received (phantom income). Zero-coupon bonds actually have MORE interest rate risk than coupon bonds of the same maturity because all cash flow comes at maturity.
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