Zero-coupon bonds are bonds that pay no interest, but rather are issued at a deep discount to face value and gradually increase in value. When the bonds reach maturity, bondholders receive the full face value of the bond.
The most popular type of zeros are known as STRIPS (separate trading of registered interest and principal of securities) that originate from Treasury issues, such as T-bonds and T-notes. A number of corporations also offer zero-coupon bonds, and those come with a higher return than Treasury-based bonds, but they don't have the same level of safety.
One of the benefits of zero-coupon bonds is that investors know exactly how much money they will receive when the bond matures. They also know when they will receive the money. .And because there are no regular interest payments, they don't have to worry about reinvesting the small payments that normally come from regular bonds.
In a nutshell, zeros are simply bonds that have been stripped of their regular interest payments and packaged and repackaged. Historically, most bonds had coupons attached to them that investors would use to redeem their semiannual interest payment. Some investment companies began "stripping" the coupons from the bonds and selling the bonds without the redeemable coupons. Thus the term "zero coupon." When a bond is stripped, each interest payment and principal payment becomes a separate zero-coupon security. When you buy a zero-coupon bond, it comes without "coupons" - regular interest payments - but rather pays you a set amount at maturity that is equal to the sum of the principal and compounded interest payments that the bond would have paid.
You can use zero-coupon bonds for your long-term investment portfolio, or you can use them to plan ahead for anticipated needs, such as college tuition for the kids, because zero-coupon bonds have a specific schedule of appreciation. You know exactly when you will receive the lump sum payment for your bond and exactly what the payment will be.
Who should buy zero-coupon bonds?
STRIPS and other zero coupons are geared to investors who want to receive a preset payment at a specific future date. Some pension funds invest in STRIPS to be sure they have adequate funds to cover future payments. Zeros are also popular with investors who buy them for their retirement accounts, 401(k)-type savings plans, and other income tax-advantaged accounts that permit earnings to accumulate without incurring immediate income tax charges.
Zeros are also popular with investors who are saving for a specific future expense, such as college costs for the kids. They are also popular with investors on a limited budget because many zero-coupon bonds are issued in small denominations of under $1000.
Conservative investors who do not need income but want safety, capital appreciation, and some tax savings may find STRIPS alluring. Other zero-coupon bonds derived from higher yielding corporate bonds may be attractive to more aggressive investors. Although zeros from corporate bonds offer neither the safety nor the state and local tax exemption that STRIPS provide, they do offer a better total rate of return.
Who should not buy zero-coupon bonds?
STRIPS would probably not be appropriate for aggressive investors looking for a high rate of return, although aggressive investors may find some corporate zeros that would provide a suitable return. STRIPS and other zeros may also be appropriate for the portfolios of nearly any type of investor interested in diversification.
