What Are Zero Coupon Bond Funds?

Definition, Timing and Risks of Zero Coupon Bond Funds

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Zero-coupon bond funds don't get much press but they can be valuable investment tools if used properly.

Many investors are unaware of the fact that there are dozens of types of bond mutual funds and that they can be used for more than just low-risk investing or for diversifying against the risk of buying and holding stock mutual funds. And there are even more investors who are unaware of the advantages of uses of zero-coupon bond funds.

Here's what you need to know about these unique fixed-income instruments:

Zero-Coupon Bonds: Definition and Basics for Investors

A zero-coupon bond is a bond that is bought at a discount (a price lower than its face value), with the face value repaid to the investor at the time of maturity. "Coupons" are another name for bond interest payments and zero-coupon bonds do not make periodic interest payments. In different words, these bonds do not pay coupons, hence the term zero-coupon bond.

The purchaser of the bond receives the full face (par) value of the bond when the bond reaches maturity. However, in contrast, an investor who owns a regular bond receives income from periodic coupon payments, which are usually made semi-annually.

Some zero-coupon bonds do not start out as zero-coupon bonds. For example, US Treasury Bonds do not start out as zero-coupon but a program known as the Separate Trading of Registered Interest and Principal Securities (STRIPS), removes the coupon, or interest payments, and creates zero-coupon bonds, also known as "STRIP bonds."

Because zero-coupon bonds do not pay interest and their par value is due at maturity, their price is more sensitive to interest rates. Therefore, not only is a falling interest rate environment good for bonds, it is even better for zero-coupon bond funds.

With regard to bond mutual funds, keep in mind that the investor owns shares of the mutual fund and not the holdings of the mutual fund portfolio. Therefore the bond mutual fund's price (or what is referred to as its net asset value or NAV) is a central function of the bond fund's total return to the investor. This is why bond mutual funds have principal risk -- because the amount invested can fall in value, whereas an individual bond holder can simply hold their bond without incurring any loss, as long as they don't sell their bond at a lower price than purchase.

Best Time to Invest in Zero-Coupon Bond Funds

Bond prices and interest rates are like two opposing ends of a teeter-totter: When one side rises, the other side falls. Therefore when interest rates are rising, bond prices are falling and when interest rates are falling, bond prices are rising. So the best time to invest in bonds is when interest rates are falling because the price (or value) of your bond investment is rising.

The only question that remains with regard to the best timing for investing in zero-coupon bond funds is: When are interest rates likely to fall? The answer is during deflationary times.

The reason is that the Federal Reserve will fight deflation, which is a period of falling prices for consumer goods and services, by reducing interest rates through the purchase of Treasury Bonds.

Best Zero-Coupon Bond Funds

A good short-term zero-coupon bond fund (for years 2014 or 2015) is American Century Zero Coupon 2015 (BTFTX) and one of the best long-term zero-coupon bond funds is an ETF, PIMCO 25+ Year Zero Coupon US Trs (ZROZ).

Investors should use caution when buying and holding zero-coupon bond funds because their prices have dramatic swings up and down. Also, long-term bonds will have greater fluctuation in price than short-term bonds.

For example, in the year 2013, ZROZ had a -20.9% return, and in 2014, the fund had an eye-popping 48.8% gain. ZROZ then turned negative again in 2015, had a low single-digit gain in 2016, then pulled ahead of the average bond fund, as measured by the Bloomberg Barclays US Aggregate Bond Index, in 2017.

Therefore the key takeaway with zero-coupon bonds is that they can be good long-term holdings but they are also volatile, market timing instruments and definitely not for beginning investors.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.