It may be difficult to think of something called "zero" as having much value, but zero-coupon bonds can play a key role in your financial planning, experts say.
Zero-coupon bonds do not pay interest until maturity. Rather, like Series EE savings bonds, they are sold at a discount from face value. The difference between the discounted purchase price and the face value at maturity is your return.
You can buy zero-coupon U.S. Treasury bonds that are backed by the government. Corporations also sell zero-coupon bonds, as do municipalities. Many of the latter qualify for an exemption from federal income taxes.
A key advantage of zeros is that you can match the maturity of the bond to a specific goal and forecast precisely what you will get back. That makes zeros a good investment for retirement and education expenses for children, experts say.
"Just about any future goal can be planned with zero bonds," said Vincent Conti, vice president and a principal at Covenant Financial Management in Winter Park, Fla.
One disadvantage comes courtesy of Uncle Sam. Although no interest is paid, the Internal Revenue Service requires bondholders to pay income tax on the theoretical interest accruals. Tax-exempt municipal zero-coupon bonds avoid that, however, as do zeros held in individual retirement accounts.
You also should be aware that many zero-coupon municipal bonds have a call feature, meaning that they can be redeemed before maturity. You get back the principal plus interest due to the call date, but the interest for years beyond the call date is lost.
Non-callable zero municipal bonds are available, but you may have to search for them, and they generally pay lower interest. Zero Treasury bonds are not callable, but federal income tax must be paid on the interest.
Zeros need not be limited to education and retirement planning, Mr. Conti said. A business might purchase zero-coupon bonds to provide key employees with deferred compensation, he said. Or you could use a zero to pay for a trip around the world. Other uses: gifts to charities or churches, and retirement of debt, including a home mortgage.
The discount at which zeros are sold depends on the time to maturity. The longer that time, the greater the discount from face value. You can buy for a return in 10 years, 15 years, 20 years or more.
Mr. Conti said that many investors use a "ladder" approach in retirement planning, buying bonds annually. As the bonds start maturing, the stated returns roll in year by year.
Glenn Repple, president of Glenn A. Repple & Co. in Maitland, said that some investors use zero-coupon bonds to offset risk-taking in more aggressive investments.
A person with $25,000 to invest might put $5,000 in zero-coupon bonds that will return $15,000 at maturity. The other $20,000 might go into more speculative investments, such as common stocks. The investor has the comfort of knowing that at least $15,000 of the investment is protected, Mr. Repple said.
With long-term interest rates now at relatively low levels, however, Mr. Repple said that he would not be inclined to put much money into long-term zeros. He noted that some zero-coupon bonds with 10-year maturities are now paying a 9 percent yield, though, "and that's not bad."
Richard Hudson, associate vice president of investments for the brokerage Dean Witter Reynolds Inc. in Orlando, said that he makes extensive use of zero-coupon bonds in his clients' portfolios because of the safety and fixed returns.
In retirement planning, you can use zero-coupon bonds to calculate the cash flows you would like each year, Mr. Hudson said.
That ability to stagger maturities appeals to Jack Nelson, president of Nelson Investment Planning Services Inc. in Maitland. Bonds can be purchased yearly with little cash outlay, and buyers know what will be returned in the future.
PD "I think they're great for grandparents who want to help out the
grandchildren," Mr. Nelson said. "They can start buying them when the child is born."
Mr. Nelson does not advocate extensive use of zeros for general investing. "There are far superior investments for future growth that provide greater returns."
He also expressed concern about the bite of inflation on zeros with lengthy maturities. And zeros with very short maturities -- say, five years -- don't have enough discount from face value to appeal to many investors, he said.
Besides the inflation bite, you need to remember that the market price of the bond will fluctuate with interest rates, said Joe Bert, chief executive of Certified Financial Group Inc., in Longwood.
"That could be detrimental if the bond is sold before maturity and rates are rising," Mr. Bert said.
The face value of the bond at maturity doesn't change. But, as interest rates rise, the market price of the bond will fall. Conversely, if interest rates fall, the market price will rise.
If the investor needs money and must sell the bonds in a market of falling rates, rather than wait for them to mature, he or she could take a severe loss.
Financial planners also warn that quality -- especially in corporate zero-coupon bonds -- is a more important consideration than with most other bonds. Because you do not receive the face value of the bond until the maturity date, the investment is at great risk if the quality of the issuer is ignored. You should note that municipalities, as well as corporations, have defaulted on bonds.