Zero Coupon Bonds
Zero coupon bonds are fixed income securities. Unlike traditional bonds, zero coupon bonds do not pay interest to the holder. Instead of receiving periodic interest payments, investors purchase zero coupons at a discounted price and collect the par amount at maturity. The three largest categories of zero coupon bonds available are zero coupon Treasury bonds, zero coupon corporate bonds and zero coupon municipal bonds. They are issued by the U.S. Treasury, corporations, and state and local government entities, respectively.
Zero coupon Treasury bonds are backed by the full faith and credit of the U.S. Government. Zero coupon corporate bonds are backed by the issuing corporation and therefore offer a potentially higher rate of return commensurate with additional credit risk. Only zero coupon municipal bonds earn interest that compounds free from federal income tax, and in some cases state and local taxes.
If you purchase a zero coupon Treasury bond or a zero coupon corporate bond, the yield is taxable as ordinary interest income every year, even though the holder receives no payment until maturity. Taxable zero coupon bonds are therefore best suited for IRA, Keogh plans, or other kinds of tax-sheltered accounts. In such accounts, zero coupon bonds offer an assured rate of growth and yields that are a function of both maturity and the credit standing of the issuer.
Advantages
Guaranteed Yield/No Reinvestment Risk - Investors in zero coupon bonds "lock in" the yield to maturity at the time of purchase. Future reinvestment risk of bond coupon interest is eliminated.
Flexibility/Maturity Selection - Zero coupon bonds are available in a wide range of maturities spanning 1 - 30 years. An investor can use these varying maturities to meet specific portfolio needs.
Potential Disadvantages
Volatility - Should an investor need or desire to sell zero coupon bonds before maturity, the market price will depend on the prevailing levels of interest rates. Zero coupon bonds are more volatile than coupon-paying bonds, a factor that will work for the benefit of the holder during falling interest rates, and against the holder during periods of rising rates.
Inflation - The "interest rate risk" associated with possible higher inflation and changing currency values will influence the investor's choice of maturity and the percentage of a long-term portfolio dedicated to zero coupon bonds.
Please contact us for a current listing of available zero coupon bonds.