Zero-coupon bonds (or zeros, as they are called) differ from other debt obligations in that they don’t pay out a stream of interest payments. Instead, they’re issued at substantial discounts and accumulate and compound the interest. Zeros often have attractive yields and are normally held by investors until maturity. At maturity, the full face amount plus all accrued interest is paid. As such, zeros have two major advantages for the investor: 1) Because of their deep discounts, they can be bought at very low prices; and 2) The guesswork is removed concerning interest reinvestment, because the yield to maturity is locked in.
The compounding interest effects of zero-coupon bonds over long periods of time can be astonishing. For example, a $1,000 U.S. government zero-coupon bond which has a 7% interest rate and 30-year maturity would double its investment in 10 years, triple it in 15 years, quadruple in 19 years, and quintuple in 22 years. It’s no wonder Albert Einstein called compound interest “the eighth wonder of the world�
Zero-coupon bonds do have several important disadvantages, however. These disadvantages include: 1) Income taxes are payable as the interest accrues and, because no current income is paid by zeros, must come from a different source; 2) The market value of zeros tends to be highly volatile; and 3) Inflation can erode the value of the bond at maturity.
There are a number of different types of zero-coupon securities:
- Corporate zero-coupon bonds are issued by corporations and are generally not recommended for individual investors because of the risk of default private companies and because the yield tends not to be very competitive in relation to the risk of the instrument.
- Strips are U.S. Treasury or municipal bonds that brokerage firms have separated (or stripped) into principal and interest components that are marketed as zero-coupon securities. These instruments are represented by certificates, with the actual securities being held in escrow, which ensures a high degree of security.
- STRIPS (Separate Trading of Registered Interest and Principal of Securities) are the Treasury’s own zero-coupon securities which are issued in the traditional way but are separated into interest and principal components at the discretion of bondholders using book entry accounts at Federal Reserve Banks. Because they are direct debt instruments of the U.S. government, they are free of credit risk altogether.
- Municipal zero coupon bonds are issued by state and local governments and are usually exempt from federal and state taxes in their state of issue. They provide a convenient way to meet the goals of high tax bracket investors who get an after-tax benefit from the lower interest rates of tax-free municipals.
- Zero-coupon convertibles are a relatively new instrument. Introduced in the 1980s, convertibles come in two forms. One is convertible into common stock which provides growth potential. The other, usually a municipal bond, converts into an interest-paying security. This allows the bondholder to lock in a rate of accruing interest for 15 years, and then afterwards begin to receive interest payments.
|
Sponsors
HOT STORIES
