Zero Coupon Bonds

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 IBCA, 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