Getting something for nothing

There are rewards for owning zero-coupon bonds

For a true “fire-and-forget” investment, zero in on zero-coupon bonds. Do you have a three-year-old child? An outlay of about $3,500 today will lock in a return of $10,000 in 2015, when those first college bills become due. Thinking about retirement in 30 years? For around $15,000 up front, you can bank on a $100,000 payoff in 2030.

“Zero-coupon bonds eliminate reinvestment risk,” says Susan Nason, senior vice president of Federated Investors in Pittsburgh. “You know exactly how much you’ll receive at a given future date without worrying about what to do with all the interest payments along the way.”

In bond-market lingo, a coupon is the interest payment a bondholder receives at periodic intervals, say every six months. If you buy a $10,000 bond with a 7% coupon ($700 per year), you’d collect $350 in interest every six months until maturity, when you’d get your $10,000 back.

Unfortunately, those periodic $350 payments are likely to be spent or squandered over the years. Or, they could be reinvested at a lower interest rate than the coupon bond.

That won’t happen with a zero-coupon bond. As the name suggests, you won’t receive any interest payments (thus the “zero coupon”), but you’ll pocket all of the interest at the bond’s maturity. What’s more, the interest will equal all of the foregone interest payments, compounded at a certain yield to maturity. In effect, the $350 payments are automatically reinvested, so you can enjoy the benefits of compound interest earned on them.

A guaranteed investment return, zeros fall into two main categories: Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) and municipals. “STRIPS are constructed from Treasury bonds by major bond dealers,” says Nason. “They offer the advantages of Treasuries, including safety, liquidity and exemption from state and local income taxes.” Most brokers sell STRIPS with a minimum investment of $5,000 (face amount of the bond at maturity).

The catch? The interest paid by STRIPS is not exempt from federal income tax. In fact, tax is owed each year on interest accumulated, but it’s not paid. In other words, you’ll accrue taxes on money you won’t receive for years. “For this reason, STRIPS generally should be held in a tax-deferred retirement plan,” says Eleanor Blayney, a financial planner and principal with Sullivan, Bruyette, Speros & Blayney Inc. in McLean, Virginia.

Another option is to buy muni zeros, which enjoy the same tax exemption as other types of municipal bonds. “You might invest $5,700 today in a municipal zero-coupon bond and get back $10,000 in 10 years, completely tax-free,” says George Strickland, portfolio manager, Thornburg Intermediate Municipal Fund in Sante Fe, New Mexico.

Strickland advises investors to shop around among several brokers before buying any type of zero, because price differences may be substantial. And unless you’re speculating that interest rates will fall, be prepared to hold a zero until maturity.

Years + Yield = Guaranteed Returns
The table shows how much you’d have to invest, and at what yield, until a $5,000 zero-coupon Treasury matures.

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