Frequently Asked Questions
Zero Coupon Bonds
These are questions from real investors phoned in to my past TV show, live. I’ve included them here in the same phrasing used by callers, which is not always the “correct” phrasing(!) But I thought that many other investors who are not bond professionals may be able to relate to the callers’ way of talking.
Some of my answers are quite long and informative. Others are short, to the point, “zesty zingers!” Sorry. No one ever accused me of being too tactful!
Zero Coupon Bonds. Please explain them and how they work.
A Zero Coupon bond is a bond that pays no interest. Its coupon equals zero %. Because it pays no interest, it is sold at a very big discount to its maturity value and its value accretes until it is worth par or face value at maturity. Its accretion rate is determined by “the market.” When we talk about the yield on zero coupon bonds, we are talking about their accretion rate. Zero Coupon Bonds are issued by the U.S. Treasury, by agencies of the U.S. government, by corporations, and by foreign governments in U.S. dollars here in America. (Note: There are also zero coupon municipal bonds, but these are a wholly different category of bonds and are discussed under “Municipal Bonds.”)
Which do you prefer? Zero Coupon bonds or Coupon Bonds?
In my opinion, Zero Coupon bonds are excellent purchases for two reasons. One, they are a great way to match a known stream of future liabilities. For instance, if you know that you are going to have to pay a fixed amount of money in the future, or an amount of dollars every year for “x” amount of years in the future, say, to pensioners or as profit sharing distributions, or as nursing home or college payments, Zero Coupon bonds are a wonderful means by which to do that. You simply buy a zero coupon bond to mature in each of the years in the amount that you need to meet that liability and then forget about them and invest the balance of your portfolio for total return growth potential.
A second reason I like Zero Coupon bonds is that they are a good proxy for playing the interest rate market. This, of course, is risky business and only meant for those with “Trader” mentality. Long-term Zero Coupon Treasury Bonds, called STRIPS, are a great vehicle for trading the interest rate market because they are very liquid and very volatile, and therefore, make a good trading vehicle.
Outside of these two reasons, I’m not a great fan of Zero Coupon bonds. I like all those old clichés about a bird in the hand is worth two in the bush, or a dollar today is worth more than a dollar ten years from now! I want to earn my interest (the return on my investment) NOW. When you buy a Zero Coupon bond, you make your earnings at the end, when it matures.
If you own a taxable Zero Coupon bond, you may pay taxes on the amount of accretion each year even though you don’t receive any money. With an interest-bearing bond, that is a bond that has a coupon above zero and pays interest every six months or periodically, one has the ability to earn “interest on interest.” Your original investment continues to earn its interest that you can reinvest in other interest-bearing securities and earn “interest on your interest” and thereby develop quite a good compounding portfolio. One gives up this opportunity with Zero Coupon bonds even though the accretion rate theoretically takes into account a compounding feature.
What is your opinion of laddered Zero Coupons for a retired person?
Not very favorable. Most retired people I know need income, and so I would want to see them in interest-bearing bonds. Indeed, you can buy Treasury bonds in amounts as small as $1,000. You can ladder a series of Treasury bonds providing interest that you can live on, while protecting your principal, and also giving you reinvestment opportunities to help keep pace with inflation.
If you don’t have enough money to ladder a Treasury portfolio, you can also buy a Unit Trust of Treasuries. This is a trust in which has been deposited a fixed number of different Treasury issues, and there is no trading that goes on within the Trust. During the life of the Trust, as the bonds mature, they are distributed to the unit holders on a pro rata basis, just as the interest which comes in each month is distributed to the unit holders on a pro rata basis.
Investors should consider a unit investment trust’s investment objective, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other important information, is available from your financial advisor and should be read carefully before investing. The value of a trust will fluctuate with the portfolio of underlying securities, such that the redemption price may be more or less than the price paid.
What is the difference between STRIPS and Zero Coupon bonds, and how do they relate?
STRIPs are those Zero Coupon bonds that have been approved by the United States Congress to be derived from 30-year Treasury Bonds. The interest payments are stripped from the principal portion of the 30-year bonds and allowed to be turned into Zero Coupon bonds derived from the principal stream or interest stream of “stripped” treasuries. These are the only Zeros that are called STRIPS. Other institutions have bought 30-year bonds and stripped them, but they are not allowed to call them STRIPS.
I have $50,000 to invest for a new grandchild. What about a Zero Coupon bond? If not, what?
You may want to consider a Zero Coupon bond, and have it mature at the child’s 19th birthday when that child assumes his or her own tax bracket. HOWEVER, over the long term, nothing has grown like the stock market, and since you have a long term before this grandchild is likely to be using this money, I would recommend investing this money in Blue Chip stocks and getting on the various dividend reinvestment programs. The returns over the long term would be, if history repeats itself (which it may not), far greater than what you might achieve in a Zero Coupon bond. Of course, you are assuming greater risks by investing in the stock market.
What are alternatives to U.S. Zero Coupon bonds?
There are government agency Zero Coupon bonds, there are corporate Zero Coupon bonds, and there are Yankee Zero Coupon bonds. Yankees are those bonds which are issued by foreign sovereigns or corporations in U.S. dollars in the U.S. market. These are all alternatives to U.S. government Zero Coupon bonds.
Where can you purchase Zero Coupon tax-free bonds outside of an IRA?
This question is a bit confused! You can purchase Zero Coupon bonds both taxable and tax-free at any brokerage house.
You can purchase Zero Coupon bonds for an IRA, but because an IRA already provides tax deferral, you would not want to buy a tax-free municipal Zero Coupon bond for an IRA account. Outside of an IRA you would only want to buy a tax-free Zero Coupon bond for someone who is in the 28% or higher tax bracket. Be advised, Zero Coupon municipal bonds do not have very good liquidity. The spread between the bid price and the offer price can be quite large.
If you buy Zero Coupon municipals for a child, who until their 19th birthday has their parents’ tax bracket as their own tax bracket, be sure that you buy these Zero Coupon munis to mature on the child’s 19th birthday. After the age of 19 (24 if full-time student), the child has his or her own tax bracket, and most 19-year-old children do not earn enough income to find themselves in the 28% tax bracket when municipal bonds become attractive.
Interest income, although not received with zero coupon municipal bonds, may be subject to the alternative minimum tax, and capital gains tax may apply if bonds are sold prior to maturity. Prices on zero coupon bonds tend to be more volatile than bonds that pay interest regularly, and the principal value of a bond is subject to market risk if it is sold prior to maturity.