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The Online Advisor - January 2000
Does your portfolio have any zeros?
With all the different investor styles and goals and the multitude of investment choices available, is there any investment that has a place in almost every portfolio? The answer is yes -- zero coupon bonds ("zeros").
Zeros are bonds that make no periodic interest payments to the bondholder. Instead they are sold at a deep discount to their face value and accrue interest until maturity. The longer the maturity, the deeper the discount. They can be purchased either individually with a set maturity date or by mutual fund. Though zeros are very useful when used appropriately, like any investment, they are not without their drawbacks and risks.
Many entities issue zeros, but the most popular zero coupon bonds are those issued by the U.S. Government which pay a guaranteed rate of return when held until maturity. Thus, U.S. Government zeros are an excellent planning tool for the conservative investor with specific long-term goals, such as retirement. For example, an individual intending to retire in 20 years would purchase a zero that matures in 20 years.
Because zeros pay no periodic interest payments, their prices are highly sensitive to changes in interest rates. Aggressive investors purchase zeros to earn capital gains. When interest rates fall, the prices of zeros rise. When interest rates rise, the prices of zeros fall. These price changes are accentuated by the bond's length of maturity and quality. Thus, zeros can be very volatile investments if not held until maturity.
The main drawback to zeros is that the bondholder owes income tax on the accrued interest each year. Therefore, it is usually recommended that zeros be placed in tax-sheltered accounts.
Call us to discuss the tax treatment and appropriateness of zero coupon bonds in your overall investment portfolio.