Investing in zero coupon bonds

Key Points

• How They Work
• The Growth of Value
• Drawbacks
• Liquidity
• How to Buy a Zero
• Types of Zero Coupon Bonds
• Points to Remember

For those investors who do not like to tinker with their portfolios on a regular basis but who do like the assurance of getting a certain, predictable amount on a fixed future date, zero coupon bonds may be ideal. Zero coupon bonds (or "zeros") are fixed-income securities that are sold at a deep discount to their face value. They are essentially bonds without any quarterly or semiannual coupons, which is where they get their name. Instead, they pay principal and interest together when the bond reaches maturity.

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How They Work

Since a zero coupon bond does not pay interest at the end of every quarter, the difference between the amount you receive at maturity and the amount you paid represents the interest payment. For example, a bond with a face amount of $20,000, maturing in 20 years, may be purchased for roughly $5,050, if the interest rate were 7%. The interest is compounded automatically until the bond matures.

Zero coupon bonds offer several benefits to investors. The biggest advantage of a zero coupon bond is its predictability. If you do not sell the bond prior to maturity, you do not have to worry about market ups and downs since you know what your investment will be worth at a particular future date. However, if you do sell prior to maturity, you could lose money because of market fluctuations.

Also, unlike most other investments, you know the amount you will receive at maturity. Zero coupon bonds are available for varying maturities so that you can custom design your portfolio to match your needs. For example, if you know that you will need money in 10 years when your child goes to college, you can buy a zero coupon bond for $465 for every $1,000 you will need.

Or, roughly $17,500 invested in zeros at a 7.1% interest rate will guarantee $100,000 in 25 years, perhaps when you are ready to retire.

The other advantage is that there is no interim interest to invest, so you do not have to make investment decisions periodically. Zero coupon bonds probably offer the best of both worlds — the predictability of a fixed-income investment with the chance of getting a higher return should interest rates decline. Typically, the value of your zero coupon bond goes up if the interest rates fall, so if you choose, you can cash in your investment for a higher return.

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The Growth of Value

This chart shows the growth of $5,000 in municipal zeros purchased on January 1, 2007, that have an original-issue yield of 4.5% and a maturity date of December 31, 2026.

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Drawbacks

Like other investments, zeros are not for everyone, and there are some drawbacks you should consider. The biggest disadvantage may be the overall tax implication. With zero coupon bonds, even though you do not receive any interest payment until maturity, the Internal Revenue Service treats assumed interest payments as income, so you pay taxes on annual income that is not realized. Of course, you do not have to worry about taxes if you are investing in a tax-deferred account, such as a retirement account or an individual retirement account. That is why zeros are very popular for any tax-deferred investments.

Keep in mind, however, that zeros issued by municipalities are generally exempt from federal taxes and possibly state and local taxes as well. Because some zeros issued by municipalities can be "callable," the issuer can call in the bond early. Before buying, therefore, ask your broker or financial advisor if your bond is callable. If the bond is not callable, make sure the official paper states that the bond cannot be called by the issuer before maturity.

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Liquidity

Although millions of dollars worth of zero coupon bonds are traded every day in the secondary markets, many zeros — especially some corporate zeros — may have limited liquidity. Also, it may be expensive to trade some zero coupon bonds in a secondary market. However, if you stay invested until maturity, you bypass the problem of liquidity with your investment.

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How to Buy a Zero

1. Look over the different types of zero coupon bond options.
2. Investigate the issuer.
3. Determine the maturity date or dates for your investment.
4. Determine the amount of money you are willing to commit to the long-term investment.

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Types of Zero Coupon Bonds

There are several types of zero coupon bonds. The most common ones are Treasury zeros backed by the U.S. government, muni zeros issued and backed by municipalities, and corporate zeros issued by corporations.

Since Treasury zeros are backed by the government, they are considered to be the lowest risk; and since they have a large secondary market, they are also most liquid. Zeros, just like any other bonds, are rated by agencies such as Moody's and Standard & Poor's. Ratings go from AAA, the highest quality, to D, which means default. "Investment-grade" bonds are rated AAA, AA, A, and Baa with various pluses and minuses within each category.

Zero coupon bonds are sold by banks and brokerage firms; however, all zeros are not created equal. You will want to know who is the issuer, since zero coupons are generally considered long-term investments. Also, zeros are sold under several different names such as Beginner bonds, Minibonds, Munisavers, Strips, or Capital Appreciation bonds. You should comparison shop before purchasing them. The price you will be quoted will be for $1,000 and usually includes a brokerage commission. The best way to approach investing in zero coupon bonds is by first deciding the maturity date or dates that you would be interested in and the amount. Next, look for the best price available in the zero coupon categories.

Unless you are looking for an investment that provides you with regular income, zero coupon bonds are definitely worth considering when you are looking over your fixed-income options. If you are almost certain you will not be in a position to sell the zero coupon bonds before they mature and paying the annual taxes is not a bother, many experts suggest investors consider including zeros in the bond portion of any college saving program.

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Points to Remember

1. Zero coupon bonds do not pay interest at the end of each quarter. Rather, the face value of the bond (at maturity) represents the interest accrued over the initial purchase price of the bond.
2. Accumulating interest on zeros is taxed by the IRS during the years in which the bond is held, even though no interest payments are made.
3. Zeros are subject to higher volatility than other bonds and an investor could lose money if a bond is cashed in before maturity.
4. The U.S. Treasury, municipalities, and corporations all issue zero coupon bonds. Zeros are rated in the same manner as other bonds by agencies such as Standard & Poor's and Moody's.
5. Zeros are sold by banks, brokerages, and financial advisors. They are sometimes called Beginner bonds, Minibonds, Munisavers, Strips, or Capital Appreciation bonds.

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Financial planning services and investments offered through Ameriprise Financial Services, Inc., Member FINRA and SIPC.

There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Non-investment grade securities, commonly called "high-yield" or "junk" bonds, generally have more volatile prices and carry more risk to principal and income than investment grade securities.