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All About Zero Coupon Bonds

Lisa Smith

Zero-coupon bonds are bonds that do not make any interest payments (which investment professionals often refer to as the “coupon”) until maturity. For investors, this means that if you make an investment today in a zero-coupon bond that matures in 20 years, you won’t put a single penny worth of income in your pocket for two decades. For some investors, that proposition has a strong appeal.

Who Would Want Them?
If you are retired and looking to generate a steady stream of income, zero-coupon bonds are probably not high on your list of potential investments. On the other hand, if you need a specific amount of income on a specific date in the future, they may be the perfect choice. Consider, for example, the future college funding needs of a young child. If your goal is to help the child pay for an education, it is fairly easy to predict the date on which the child will need the money. Purchasing zero-coupon bonds that mature on the date the child will need the money can be a convenient way to help cover the expense.

Zero-coupon bonds are also appealing for investors who wish to pass wealth on to their heirs but are concerned about income or gift taxes. If a zero-coupon bond is purchased for $1,000 and given away as a gift, the gift giver will have used only $1,000 of his or her yearly gift tax exclusion. The recipient, on the other hand, will receive significantly more than $1,000 when the bond matures. Similarly, tax-free zero-coupon bonds make good gifts for children who generate more than $1,800 in annual income and are subject to taxation on earnings. The bonds will provide income for the children without increasing their tax liabilities.

Zero-coupon bonds are also an interesting option for investors with little interest in watching the financial markets move up and down. You just buy the bond and wait for it to mature. It’s a simple way to implement a “set it and forget it” investment strategy.

Issues and Issuers
Zero-coupon bonds come in many varieties. Two of the most common include the issuer and the tax status. Zero-coupon bonds may be issued by federal, state or local governments or by corporations. Perhaps the version most familiar to many investors is the old Series EE savings bonds issued by the U.S. government that were often given as gifts to small children. These bonds were popular because they could be purchased in small denominations. For example, a $50 bond could be purchased for $25. The child would keep the bond for several decades and then, when it matured, received $50. While the savings bond program has been changed, and these bonds are no longer available, the concept is still a valid example of how zero-coupon bonds work.

From a tax perspective, zero-coupon bonds issued by government entities generally come with an attractive degree of exemption from income tax. For example, some of these bonds are triple tax-free, as the income they generate is exempt from income tax at the federal, state and local levels. Various local municipalities are significant issuers of zero-coupon bonds as they seek to raise capital to support infrastructure and other projects. Others offer limited tax exemption. In either case, paying less in taxes is always good news, because it puts a greater percentage of the earnings generated by the investment into investors' pockets instead of going to the tax man.

Some zero-coupon bonds are issued by corporations. While earnings from these bonds are taxable, the interest rate they offer is likely to be higher than the rate offered on a tax-free bond of similar maturity and credit quality. In a twist on these offerings, some zero-coupon corporate bonds can be converted into shares of stock in the issuing company. These bonds are called “convertibles".

Zero-coupon bonds can also be created by banks and brokerage firms. These entities take a regular bond and remove the coupon to create a pair of new securities. This process, often referred to as “stripping” as the coupon is stripped out of the bond, results in a zero-coupon bond that can be sold to investors - plus, the future interest payments can also be sold to investors.

Unique Characteristics
Zero-coupon bonds are bought for a fraction of face value. For example, a $20,000 bond can be bought for far less than half of that amount. If issued by a government entity, the interest generated by a zero-coupon bond is often exempt from federal income tax, and often from state and local income taxes too. If purchased from a corporation, the interest is not paid until maturity, but investors must pay income tax each year on the earnings that they have not yet received. For this reason, zero-coupon bonds issued by corporations are often purchased in tax-deferred accounts such as Individual Retirement Accounts.

Zero-coupon bonds may not reach maturity for decades, so it is important to make sure that any bonds purchased have been issued by creditworthy entities. Some of them are issued with provisions that permit them to be paid out (called) before maturity. Investors counting on a specific payout on a specific date should be aware of these provisions to avoid the implications of what professional investors refer to as "call risk".

Also, the bonds' daily prices fluctuate on the open markets, so investors who sell them prior to maturity may receive more or less money than they originally paid for the bonds. Of course, if held until maturity, the payout will be predetermined and does not change.

How to Buy
Zero-coupon bonds issued by the federal government can be purchased directly from the government at the time they are issued. After their initial issuance, they can be purchased on the open market through a brokerage account just like other bonds. Other types of zero-coupon bonds can also be purchased using a brokerage account.

Financial advisors often provide guidance for investors interested in purchasing zero-coupon bonds. These advisors help their clients review the marketplace of available bonds and select the most appropriate offerings based on the investors’ goals and risk tolerance.

Of course, a little bit of personal due diligence is always a good idea. To get familiar with the marketplace, just go to your favorite search engine and look for “taxable tax-exempt yield equivalent 2013” to find websites that let you compare the yields offered by tax-exempt bonds with the yields offered by their taxable peers. This information will provide some insight into the value of the tax deferral, and it may help you narrow down the field of potential investments.

The Bottom Line
Like most investment vehicles, zero-coupon bonds are like tools in a toolbox. Picking the right tool for the job can help you achieve your objective. A little time and effort, to make sure you understand the investment and have made the right choice for your needs, can go a long way toward helping you feel comfortable and confident enough to wait many years (or decades) for your investment to mature and pay out your earnings.

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