Zero Coupon Bonds

Zero Coupon Bonds

As a straightforward, basic financial tool, zero coupon bonds gained tremendous popularity in the 1980s because of certain tax code advantages. Whereas those tax loopholes have since been closed, zero coupon bonds remain popular because they are an easy-to-use investment instrument.

However, before you decide whether or not zero coupon bonds are right for your portfolio, it is important to understand the operational underpinnings of this financial tool.

Understanding zero coupon bond fundamentals

A zero coupon bond is a bond, stripped of its interest coupons, that you purchase for less than face value. You do not receive interest while you hold the bond, but the bond will pay its full face value when it has matured. Therefore, the investment component of zero coupon bonds is the appreciation of your original discounted investment to the full face value received upon maturity.

The attractive aspect about zero coupon bonds is that the person buying them knows exactly how much they will receive, regardless of what happens in the market before the maturity date has been reached. Zero coupon bonds can also be used for a variety of financial aspirations, such as long term goals like planning for college or retirement.

You can purchase zero coupon bonds from the U.S. Treasury, as well as state and local governments, municipalities, and corporations. Zero coupon bonds from the U.S. Treasury are usually the safest, as they are backed by the credit of the federal government. Zero coupon municipal bonds are also safe, as many have insurance. Zero coupon corporate bonds have a higher degree of risk, depending on the corporation that is issuing them, but will also have the largest returns.

Profiting from zero coupon bonds

There are several distinct advantages to investing in zero coupon bonds. For the beginning or average investor, zero coupon bonds are a great financial tool because they have a low minimum investment. You purchase the bond at less than face value, which means you are required to invest less at the beginning. The longer it takes for a zero coupon bond to mature, the less you will have to pay for it.

Zero coupon bonds also can offer you protection from reinvestment risk. Because you do not receive interest until your bond has matured, you do not have to worry about reinvesting interest later on when rates are lower. The yield of your zero coupon bond will remain the same until maturity.

For the most part, the zero coupon bonds are liquid securities. Therefore, if you need your investment funds returned, you can sell the bonds prior to maturity. However, you should keep in mind that if you redeem your bond prior to maturity, you may receive more or less than what you paid depending upon the current market conditions.

In addition, you benefit from flexibility with zero coupon bonds. You can choose zero coupon bonds that mature anywhere from one to 40 years. Therefore, if you are planning for a specific event, such as your retirement or your child’s first year of college, you can pick a zero coupon bond that will mature when you need it.

Of course, the greatest inherent risk of a zero-coupon bond is that it will default, leaving you with none of your initial investment. Whereas bonds that pay a regular interest offset your initial investment risk, a zero coupon bond is completely dependent upon the maturity payment. If you are looking for a risk-free investment, then a treasury bond, or a municipal bond backed by insurance, may be the best choice for you. However, if you wish to reap increased returns, in exchange for higher risk exposure, then corporate zero coupon bonds can be a good addition to your portfolio.

Like any investment tool, the risk-to-reward ratio dictates how much profit you stand to gain in relation to your risk tolerance. Investing in zero coupon bonds can be a great asset to your portfolio, as long as you make the proper decisions regarding your risk exposure levels and desired returns.