zero-coupon bond investment & finance definition

Case Study Zero-coupon bonds offer advantages, at least to some investors. Zero-coupon bonds present an investor with the certainty that the rate of return earned on reinvested interest payments will be zero because no payments will be available for reinvestment. Zero-coupon bonds accumulate interest each period until they become worth their face value on the scheduled maturity date. Buy a 7% zero and you will earn 7% both on your original investment and also on the interest that is added to your original investment every six months. A fixed reinvestment rate is an advantage if you believe interest rates are likely to fall—there is no concern about reinvesting interest payments at a rate lower than 7%. Of course, if interest rates subsequently increase, the owner of a zero-coupon bond will be worse off because interest payments could have been reinvested at a rate higher than 7%. This is a downside to earning the guaranteed rate. Zero-coupon bonds, especially issues with long maturities, tend to have very volatile prices. Buy a zero-coupon bond with a 25-year maturity and watch the price plummet if market interest rates increase. Of course, the opposite also holds true. A long-term zero-coupon bond will produce substantial gains in value when market rates of interest decline. Invest in a 7% zero-coupon bond before a major decline in interest rates and you will own a very valuable asset. The price volatility of long-term zero-coupon bonds subjects an investor to substantial risk in the event the bond must be sold prior to maturity. Zero-coupon bonds also often suffer from a lack of liquidity and so may be difficult to sell at a fair price before maturity. Again, liquidity is important if you may be required to sell the security on relatively short notice. However, if you plan to hold the bond to maturity, a lack of liquidity is not a problem. It is important to recognize that interest accumulations on corporate and U.S. government zero-coupon bonds must be reported as taxable income each year even though you do not receive any interest payments. This may result in a cash flow problem since money (specifically, taxes) will be going out and no money (for example, interest income) will be coming in. If interest from the bond is exempt from taxes (such as with an obligation of a state or municipality), or if a taxable issue is held in a tax-sheltered retirement account, taxability will not be an important issue.

What are the advantages and disadvantages of buying zero-coupon bonds? Who should buy them?

Zero-coupon bonds are quite useful in financial planning because they permit you to plan with certainty for specific rates of growth on the monies invested in them, provided that those monies will be left intact until maturity. If, however, you need to liquidate your zero-coupon bonds before their maturity, you will find that since you purchased your bonds, their prices will have moved dramatically in a direction opposite that of interest rates. These bonds have the most volatile price movements of any bonds in their respective credit quality and maturity group because they pay no coupon interest to cushion the blow of any change in interest rates. Another important aspect of zero-coupon bonds relates to their taxation. Income is accrued on zero-coupon bonds even though they do not pay any interest before maturity. If the bond is taxable (that is, it is a U.S. Treasury bond or a corporate bond), you will have to pay annual federal income tax on the accrued income even though you did not receive any cash flow from the bond before maturity. The income is based on the accretion of the bond from the discount price at which you bought it to the par value it will grow to have at maturity. If your bond is a municipal zero-coupon, the accretion is still calculated each year, but the bond's accretion is not taxed at the federal level. (Consult your state's tax laws regarding the taxation of the accretion.) This accretion affects the municipal bond's book value, however, which in turn influences the portion of any capital gain subject to federal income tax. Taxable zero-coupon bonds are often used in retirement plans and in children's custodial accounts because of the predictability of their values at maturity and the fact that income earned in accounts of this sort is generally able to grow tax-deferred or is taxed at a low federal income tax rate. Tax-exempt zero-coupon bonds are often used to form a “Side-IRA,” which means that a pool of money is able to grow, free of taxation, with its anticipated use being to enhance the pool of money that is allowed to grow within an IRA. The obvious result is that more money will be available at the time of retirement because of careful planning for tax savings and the continuous compounding of the tax-favored rate of return.

Stephanie G. Bigwood, CFP, ChFC, CSA, Assistant Vice President, Lombard Securities, Incorporated, Baltimore, MD