STRIPS and other zero-coupon bonds are available only through banks and brokers. You cannot buy STRIPS directly from the Treasury as you can with other Treasury securities because the original bonds are purchased by brokerage companies and "stripped" of their income component ( known as the "coupon") before they are repackaged into zero-coupon bonds. When a bond is stripped, each interest payment and the principal payment becomes a separate zero-coupon security.
Zero-coupon bonds are available in a wide range of denominations, from a few hundred dollars to tens of thousands of dollars. When you buy zeros, you pay less than face value, and when redeem them years later, you receive the full face value. For example, if you bought a 10-year STRIPS with a $1000 face value, you would pay about $527. That balance would grow steadily at a 6.5 percent rate. After 10 years, you would receive a $1000 principal payment, which would include your $527 initial investment along with $483 in interest accrued over the 10-year life of the bond.
You pay no commission to purchase zero-coupon bonds from brokers, but the sale price will include a markup that the broker pockets.
STRIPS are very predictable investments and very safe because they are based on bonds issued by the U.S. government. When the STRIPS matures, you will receive the full par value.
However, zero-coupon bonds based on other types of bonds, such as municipal and corporate bonds, carry a higher risk of default. Worst-case scenario, you could lose your entire investment if the bond issuer defaults. That is not likely to happen with A-grade corporate bonds, but it has happened on rare occasions with junk bonds and municipal bonds, so there is some risk factor.
The other concern is that if you buy long-term zeros during periods of low interest rates, you could see a rise in rates, leaving you with one of the lowest-yield bonds on the market. But if you tried to sell your bond to reinvest at a higher rate, you would have to sell it at a discount because bond values decline as market interest rates rise.
The best time to buy STRIPS and zero-coupon bonds, as with nearly all traditional types of bonds, would be during periods of high interest rates. It can be difficult to predict the movement of interest rates, but as interest rates drop, the value of existing bonds increases. Buying a fixed-rate investment near the peak of interest rates would put you in a very strong position. As interest rates drop, you could hold the bond and continue to enjoy high returns, or you could sell the bond at a premium, earning a tidy profit on your investment.
By contrast, the worst time to buy zeros would be during a period when interest rates are low and are beginning to rise. That would put you in the unenviable position of either earning low rates throughout the term of the bond or selling it out at a loss. You could opt for bonds with shorter terms, but the shorter the term, the worse the return. When rates are low, your options are all less than ideal.
STRIPS investors receive a report each year from their financial institution displaying the amount of STRIPS interest income they earned for that year. That statement is known as "IRS Form 1099 - OID," the acronym for original issue discount. You would receive a similar statement from the issuers of other types of zero-coupon bonds to help you keep track of your bond's status. You can also find current bond rates and other information about bonds and STRIPS at the federal government's own web site.
