A zero coupon bond fund is a fund that invests in zero coupon bonds, which don't pay interest. The price of these bonds may be more likely to fluctuate than other kinds of bonds.
Here's what you need to know about these unique fixed-income instruments.
What Is a Zero Coupon Bond Fund?
A zero coupon bond is a bond that doesn't offer interest payments but sells at a discount—a price lower than its face value. The bondholder doesn't get paid while they own the bond, but when the bond matures, they will be repaid the full face value. Zero coupon bond funds are funds that hold these types of bonds.
"Coupon" is another way to refer to bond interest payments. The kinds of bonds discussed here do not distribute interest payments, hence the name "zero coupon bond."
Zero coupon bond funds are one of the dozens of types of bond mutual funds that investors can use to hedge their portfolios against the risk of stock investments.
How Does a Zero Coupon Bond Fund Work?
Zero coupon bond funds don't get much press, but they can be valuable investment tools if used properly. The purchaser of the bond usually receives a steep discount, so it can result in substantial gains when they receive the full face value (also known as the par value) at maturity.
Some zero coupon bonds do not start as zero coupon bonds. For example, U.S. Treasury Bonds start out offering coupons, but a program known as the Separate Trading of Registered Interest and Principal Securities (STRIPS) removes the coupon, creating zero coupon bonds known as "strip bonds" or simply "strips."
Zero coupon bond funds bundle together these types of bonds just like any other type of fund. A manager picks an index to track and aims to replicate the performance with a basket of securities that investors can buy into. These funds may be structured as a mutual fund or as an exchange-traded fund (ETF).
Keep in mind that investors who buy shares of a mutual fund own shares of that mutual fund—not the holdings of the mutual fund portfolio. Therefore, the bond mutual fund's price (known as the "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, while investors who buy bonds don't. The amount invested in a mutual fund can fall in value, whereas an individual bondholder can simply hold their bond to maturity without selling.
Best Time to Invest
Bond prices and interest rates are like two opposing ends of a teeter-totter—when one side rises, the other side falls. When interest rates are rising, bond prices are falling, and vice versa. In a hypothetical scenario that gives you perfect market timing, the best time to invest in bonds is just before interest rates start falling. In reality, it's impossible to know for sure when bond rates will rise or fall.
Investors should use caution when buying and holding zero coupon bond funds because their prices have dramatic swings up and down. Also, zero coupon bonds are typically long-term bonds with 10-year timelines or more, and long-term bonds experience greater fluctuations in price than short-term bonds.
While it's impossible to have perfect foresight, certain market conditions do push interest rates up or down, and investors should watch for those conditions. For example, interest rates are more likely to fall during deflationary times. Deflation causes the prices of goods and services to fall, which in turn hurts businesses. That's why the Federal Reserve fights deflationary forces. One of the ways in which the Fed fights deflation is by reducing the interest rates for Treasury bonds.
The opposite of this scenario also holds true. When inflation causes the prices of goods and services to rise (which is bad for consumers), then the Fed will raise interest rates. As a result, bond prices usually fall during periods of inflation.
Since zero coupon bonds don't pay interest, investors are solely concerned with the price, so these products experience greater price fluctuations than other types of bonds.
- A zero coupon bond fund is a fund that contains zero coupon bonds.
- Zero coupon bonds don't pay interest, but they are purchased at a steep discount and the buyer receives the full par value upon maturity.
- Zero coupon bond funds can be structured as a mutual fund or an ETF.
- Zero coupon bonds typically experience more price volatility than other kinds of bonds.