Zero coupon bonds, more commonly known as "strips" or "zeros", are fixed income securities that unlike other bonds, pay no interest until maturity. This means that instead of paying semi-annual interest like other bonds, the interest is compounded throughout the life of the bond and is paid in full upon maturity. Zero coupon bonds are ideal long-term investments for people who have a specific situation, which calls for a specific amount of money to be acquired at a future date, mainly ten to twenty years in the future. These bonds offer a great variety of benefits that are attractive to investors who are looking for more of a long-term investment.
They also pose a few drawbacks, but are outweighed by their advantages which make them a sound investment. Zero coupon municipal bonds combine the benefits of the zero coupon instrument with those of tax-exempt municipal securities and offer the following advantages: Low Minimum Investment The first thing that comes to mind when investing in zero coupon bonds is its low initial investment. Zeros are sold at a deep discount relative to other bonds and therefore can be purchased with a low minimum investment. Investors purchase zeros for much less than their face value, which is typically in increments of $5000, however, zero-coupon bonds with face values of $1000 are also sold.
The greater the number of years a zero-coupon bond has until maturity, the less an investor has to pay for it. The reason of such a low initial investment is another benefit of zeros, compounded interest. The small initial dollar outlay makes zeros attractive investments for many investors. It allows investors to put aside a modest amount of money today and know exactly how much they will receive at a specific future date. Tax Advantages Another benefit of zero-coupon bonds is its possible tax advantages.
Interest on municipal zero-coupon bonds is exempt from federal income taxes and, in many cases, free from state and local taxes. Because municipal zeros offer the benefit of compound interest free from federal taxes, they provide returns that are often much higher on a net basis than comparable taxable securities. 'Zeros purchased prior to April 1993 and held to maturity are not subject to capital gains tax unless they are purchased at a price lower than the compound accreted value (CAV). The sale or exchange of tax-exempt zeros purchased after April 1993 will result in taxable ordinary income if purchased at a price lower than the CAV. The CAV is the cost of the bond increased each year by the amount of the original issue discount (OID) interest earned. While the accrual of interest is tax-free for federal income purposes, the cost basis must be determined for purposes of computing a gain or loss on the sale of the security' [Smith Barney, 2004].
No Reinvestment Risk Since the interest income of zeros is automatically reinvested at a guaranteed rate, which compounds over the life of the bond, there is no risk that goes along with the reinvestment. Investors are not subject to fluctuations in their rate of return and do not have to deal with the time consuming task of reinvesting small amounts of interest income. The bond itself is invested at a fixed interest rate because of the possibility of future declining interest rates. This is another reason why there is practically no risk for reinvestment. Liquidity Liquidity poses as a benefit for zero coupon bonds because of the demand for them in an active secondary market.
Because of zeros active secondary market, it allows investors to sell the bonds prior to maturity. As with most fixed income investments, the value of zeros sold prior to maturity will vary depending on current interest rates. Since we know that zero coupon bonds are so much more volatile than other bonds with similar maturities, the volatility tends to favorably affect the value of zeros in a declining interest rate environment. On the other hand, in a rising interest rate environment, it can adversely affect its value. Quality The majority of zero coupon municipal bonds are rated A or better by Moody's Investors Service, Standard & Poor's, and Fitch IBC A, three major services who rate bonds.
Bonds are rated from AAA to D, representing default. Also, many zero coupon bonds are rated AAA showing that they have the highest quality compared to other municipal bonds. This is another advantage of investing in zeros and investors are sure they will have a high degree of credit quality, depending on the particular issues they select. Compounded Interest Another benefit of zero coupon bonds and probably one of the major ones is its incorporation of compounded interest. Instead of receiving periodic interest payments, as with most bonds, zero coupon bonds pay no interest until the bond matures. The interest accumulates and is paid out in a lump sum at maturity.
This interest is compounded and is included in the face value, which is paid at maturity because of the deep discount that the bond is being sold at. So basically, at the maturity date, the investor receives the entire face value of the bond with all the interest already included. As zero coupon bonds do have some attractive qualities that make them a good investment, they only perform their best if they remain long term investments, meaning if they are held to maturity. Since these bonds mature at a specific date you set, they are ideal for long-term situations such as retirement planning and college funding because you will acquire the capital invested at that date. Zeros can be beneficial when planning for retirement and can provide a reliable stream of retirement income.
All that is to it is to determine precisely when you plan to retire. You then purchase the zero bonds to match that date with the bonds maturity date. You can purchase different bonds at different times to guarantee a steady income. With this retirement planning, you are guaranteed a low initial cost and high credit quality. In addition, if you put your investment in a qualified retirement account such as an IRA or 401 (k), the interest can grow tax-deferred until it is withdrawn. Funding for college can also be raised through investing in zeros.
To do this, you would purchase zero bonds to mature when you intend to pay for future college tuition. The investor could purchase as many bonds as he wishes with face values that will cover the estimated cost of the future tuition. However, before an investor could purchase the bonds, he would need to determine the future cost of tuition, years from today, to know exactly how much to invest. As with retirement planning, this investment also includes the benefits of low initial investments and high credit quality. Zero coupon bonds also offer several variations of its tax-exempt municipals.
Such variations include convertible zeros and stripped municipals. Convertible bonds are hybrid bonds, which are first, issued as regular bonds, but then later, can be converted into securities and sold as shares of stock. The difference between regular convertible bonds and convertible zero coupon bonds is the interest. In dealing with convertible zeros, they are issued at a discount from par and initially pay no interest. The interest is automatically reinvested and is compounded at a fixed rate until the conversion date, which is when the bond is converted into shares of stock. The conversion date for convertible zeros is typically ten to fifteen years from the original issue of the bond.
When it is time to finally convert the bond, it is converted into interest paying tax-exempt securities rather than the compounded interest found in other zero coupon bonds. Stripped municipals are another variation of tax-exempt municipals. They are called stripped because they are "stripped" or separated into two component parts, the principal and the interest. The cash flows from the coupons are repackaged into these stripped municipals with a greater variety of maturities. Since these stripped municipals are a fairly new product, they are not so active in the secondary market as original issue zeros are. While zero coupon bonds certainly do offer a wide array of benefits that follow its services, they do encompass a few disadvantages that may not reflect best on them.
Such shortcomings include the volatility of the bond, certain required tax payments, and possibility of the bond being callable. The first big drawback of zeros is the volatility of the bond. Zeros are extremely volatile investments. This means that if the interest rate changes, it can swing the price of the bond in either direction. However, this is only a problem if the bond is sold before maturity. If the bond is held to the mature date, the investor will receive the full face value.
If the bond is sold before it matures, there could be a possibility that the investor could lose money. Another inconvenience that zeros offer is its possible tax charges. Although zeros don't include any coupon payments because they pay no annual interest, the investor is still obligated to pay income tax on the interest he would of earned for the year even though he didn't receive it. Of course there are ways around this if you invest in tax-exempt municipals where there are no charges. One more drawback of zeros is that they can be callable. This means that the issuer has the right to repurchase the bond back from the investor at any time before maturity.
If the issuer repays the bond at a certain percentage rate, it can potentially lose money for the investor. You would also have to pay a capital gains tax if the IRS thinks you made more than you should.