The return from zero-coupon bonds is about the same as any other bond - the difference is that the gains come at the end when the bond matures instead of in regular payments throughout the term of the bond. T-bonds have had an average annual return of about 5.3 percent since 1925, which is somewhat higher than the shorter-term T-notes. Triple-A corporate bonds have averaged about 5.8 percent since 1925, while high yield (junk) bonds offer yields of 2 to 4 points higher than the blue chip bonds. By comparison, blue chip stocks have averaged about 10.7 percent per year since 1925.
Bond returns can vary greatly from year to year. Returns for T-bonds and T-notes hit double-digits in the early 1980s as high as 14 percent - but dropped to less than 5 percent in 2003. In 2003, while T-bonds were paying about 4.9 percent, 10-near Treasury notes were paying only about 3.9 percent. The shorter the maturity, the lower the yield. Seven-year Treasury notes were paying 3.44 percent, and two-year notes were at just 1.56 percent.
Zero-coupon bonds carry risks similar to the bonds from which they originate. STRIPS are as safe as any other Treasury security, which are considered among the safest of all investments because they are backed by the full faith and credit of the U.S. government. On the other hand, zeros from AAA corporate bonds would be considered very safe, but not as safe as STRIPS, while zeros from junk bonds would be considered the riskiest of all zero-coupon bonds.
Market prices of zero-coupon bonds can fluctuate more than the prices or traditional bonds with the same maturity because the market price reflects the fact that there is only one payment for zeros, which is to be made well into the future. By contrast, traditional bondholders have a little more certainly with their returns because they receive a steady stream of interest payments throughout the life of the bond. The longer the maturity of zero-coupon bond, the greater the potential for market price fluctuation.
Zero-coupon bonds can offer several solid benefits:
- No interest payments. Rather than receive a series of small interest payments that you may need to reinvest, zero-coupon bonds pay you lump sum upon maturity.
- East to buy. Zero-coupon bonds are readily available through many banks and brokers.
- Liquidity. You can resell your zero-coupon bonds on the secondary market through a broker.
- Tax benefits for STRIPS. Gains from Treasury STRIPS are exempt from state and local taxes.
- Safety for STRIPS. STRIPS are very safe because they are backed by the U.S. government, although other types of zeros not backed by the government do not offer that same level of safety.
- STRIPS are noncallable All Treasury securities are noncallable, which means they cannot be redeemed by the government before maturity - unlike many bonds issued by corporations and municipalities. Sometimes when market interest rates start to fall, some corporations and municipalities pay off their bonds early and reissue new bonds at the lower rate. That would not happen with STRIPS because they are noncallable.
