BONDS #7: Zero Coupon Bonds

A fixed-income investment that doesn’t pay the investor any income!? This sounds like an oxymoron!

But zero-coupon bonds don’t, in fact, pay any coupon interest to the investor, and yet may have very good returns and some very good uses. There are times when they are a very savvy investment!

First off, a question: How does anyone make money from a bond investment that pays no interest? Answer: by buying it at a deep discount. The return on your investment would come from the price increase between the time of purchase and the maturity date. This gradual rise in price is referred to as amortization. Zero-coupon bonds can be sold prior to maturity, and the sale price will also reflect this gradual move from purchase price to maturity value, modified of course, by current market conditions.

For example, if you invested today in a zero-coupon bond that matured at its face value of $1,000 in 10 years, you would need to spend about $500. The return, or yield on your $500 investment, would be about 7 ¼%.

By comparison, you could also buy an interest-bearing bond with a coupon of 7 ¼%. All things being equal, you would pay par (or 100), investing $1000 and receiving $1000 at maturity in 10 years. The difference is that you would receive $72.50 in interest each year, or $725 over the next ten years.

When would one or the other be preferable? If you are retired and need current annual income, you would choose the coupon-bearing bond. If you want a gift for a new baby that will help with college tuition or wedding expenses, a 20-year zero might be better.

From the viewpoint of investment strategy, if you have no need for current income, and you believe interest rates are fairly high at present, you might prefer a zero. Why? Because you can lock in a 7 ¼% yield, and not worry about reinvesting interest income in the future. (Most people don’t realize that the yield to maturity on an investment assumes that the future stream of interest payments will be able to be reinvested at the same high level.

If not, the overall return on one’s investment can be lowered dramatically.

When would zeros be a poor idea??

When you believe interest rates are fairly low.

You would be locking in a lower yield with no current income that you could invest at higher levels. Income flows, reinvested at higher levels, would have limited the pain of an investment made when rates were low.

From a tax angle, the best account to invest in zero coupon bonds is a tax-free account, such as a 401-k.

For tax purposes, zero-coupon bonds are assumed to receive interest payments each year equal to the yield they earn on your investment. (This is the same as the amount of amortization, or price change they gain each year as they move from purchase price to face value at maturity.)

If the bonds are held in a taxable account, you will have to pay tax on this ‘assumed income’ out-of-pocket. This sounds awful, but if you have bought bonds at a really good yield, it may not be too bad. You are paying tax for one-year’s gain--certainly better than paying tax on the whole jump in value at maturity. This is a point you should discuss with your tax advisor. Many investors, however, buy and hold zeros in their tax-exempt accounts. Others use them as gifts to minor children, and these accounts have limited tax liability until the child actually has an income at a taxable level.

If you have scheduled your bond investments to mature each year, to provide cash for annual living expenses, then investing in zero coupon bonds is a good way to provide for a fixed face amount that will be there when you need it.

Conversely, should you need cash unexpectedly when bond prices were generally low, you would not want to be holding only zero-coupon issues. These bonds have greater price fluctuation than coupon bonds. Without the constant flow of interest payments, zeros have little to cushion them from interest-rate volatility. Simply put, their prices move up and down more dramatically than interest-bearing issues. Thus, for the average investor, zero coupon bonds should be bought with the intention of holding them to maturity.