Understanding Zero Coupon Bonds
Does paying tax on interest you haven’t received sound like a good idea? That’s what you do with zero coupon bonds and it can make good sense in the right circumstances.
Zero coupon bonds or zeros don’t make regular interest payments like other bonds do. You receive all the interest in one lump sum when the bond matures.
You purchase the bond at a deep discount and redeem it a full face value when it matures. The difference is the interest that has accumulated over the years.
Zero coupon bonds generally come in maturities from one to forty years. The U.S. Treasury issues are the most popular ones, along with municipalities and corporations.
Here are some general characteristics of zero coupon bonds:
- Issued at deep discount and redeemed at full face value
- Some issuers may call zeros before maturity
- You must pay tax on interest annually even though you don’t receive it until maturity
- Zero coupon bonds are more volatile than regular bonds
Of the three kinds of zero coupon bonds, U.S. Treasury bonds are the most popular.
However, the U.S. Treasury doesn’t issue them directly; you have to buy “STRIPS” from qualified financial institutions or brokers.
STRIPS stands for Separate Trading of Registered Interest and Principal of Securities and it means a financial institution has taken a regular U.S. Treasury issue and separated the principal and interest payments into two separate securities.
The normal income is packaged and sold to investors who need a reliable cash flow and the principal becomes a zero coupon bond.
Full Faith and Credit
Although you buy the STRIP (they come in other names also) from brokers and financial institutions, they still carry the full faith and credit of the U.S. government making them the safest of investments from a credit risk perspective.
Municipalities and corporations also issue zero coupon bonds. They have the same basic feature of being sold at a deep discount and redeemed in the future at full face value.
However, some of these issues may have call features allowing the issuer to redeem them before maturity. Be sure a check what if any those provisions are before you invest.
Municipal zero coupon bonds are free from federal income tax like regular municipal bonds.
The major credit agencies rate most zero coupon bonds for credit worthiness. This rating can change during the life of the bond, which can affect the price.
Risk of Default
Corporate zero coupon bonds carry the most risk of default and pay the highest yields. Many of these have call provisions.
How big of a discount will you pay? The U.S. Treasury provided this example:
“For example, assume that three STRIPS are quoted in the market at a yield of 6.50 percent.
- The price for STRIPS with 25 years remaining to maturity would be $202.07 per $1,000 face amount
- That for STRIPS with 10 years remaining to maturity would be $527.47 per $1,000 face amount
- That for 2-year STRIPS would be $879.91 per $1,000 face amount.”
As you can see, the farther out you go the lower your front-end cost and the more work compounding does to get you to the full face value.
You buy zero coupon bonds a deep discount to face value. You receive no interest until maturity; however, in most cases, you do owe taxes annually on the interest as it accrues.
In Part Two
In part two, we’ll look more closely at the tax implications of zero coupon bonds and examine how you can use zeros to meet your financial goals.