(FORTUNE Magazine) – Looking to lock in today's high interest rates and make a bundle down the road? Nothing packs the wallop of zero-coupon bonds. Instead of throwing off regular interest payments that the bond owner might have to reinvest at lower rates, the zeros compound interest silently at a guaranteed rate and pay it out in a lump sum upon maturity. The only problem with U.S. Treasury zeros, the most popular variety, is the way they are taxed. Though investors receive no interest until maturity, they must pay a tax each year as if they had. That annual bite turns off many taxable investors. But the taxable crowd has another way to cash in. For the past few years states and municipalities have been issuing tax-free zeros at interest rates that can exceed 10%. Thanks to the marvels of compounding, a new 30-year zero bought at a 10% yield will grow 19-fold by maturity. Technically municipal zeros aren't quite the same as the Treasury breed. Because the Treasury doesn't issue zeros as such, securities firms create them by ''stripping'' interest coupons from bonds and selling a package of coupons with the same payment date. Municipal zeros, on the other hand, begin life as true zeros: non-interest-paying bonds sold at a discount and ultimately redeemable at much higher face values. Municipal zeros have a few drawbacks. The biggest is that the issuer can call, or redeem, them long before maturity if interest rates fall. That could bring disappointment later on, notes Dennis Boyle, a senior municipal underwriter at Merrill Lynch. ''The biggest kick from a zero,'' he explains, ''comes in the last five to seven years of its life.'' Assume, for example, that an investor purchases a 30-year municipal zero with a stated interest rate of 10.25%. By the 25th year, because of heavy compounding, the value of the bond would be 12 times greater--and the annual interest 11 times greater--than in the first year. ''Before buying one of these, it's critical to carefully scrutinize the call provisions,'' advises Robert Adler, a vice president at Shearson Lehman. Housing bonds, issued by state mortgage agencies, can be called away early for a variety of reasons. The mortgage agency may be unable to lend out the money raised, or borrowers may pay off the mortgages ahead of time. Analysts are quick to add, however, that the plump yields on muni zeros--up to three- quarters of a percentage point over those on coupon-bearing munis--more than compensate for these risks. Like all callable bonds, most muni zeros can't be redeemed before a stated date. Even then, the issuers usually pay a premium over the accumulated value. The state of Michigan 10.25% zeros due 2011, shown above, are callable beginning in the year 2000. At that time the issuer promises to pay 105% of the principal and accumulated interest. The call premium declines thereafter, and from the year 2005 on, the issuer can redeem the bonds without paying anything extra. Antsy investors who want to sell out early face another problem. ''The market for zeros is so thin that someone trying to sell them before maturity could take a substantial loss,'' warns John Noonan, head of municipal finance at John Nuveen, a municipal bond underwriter. ''These bonds should be bought by people who won't need the money anytime soon.'' While safe from the long arm of the Internal Revenue Service, muni investors face state and local taxes on out-of-state securities. The taxes are figured in different ways. New York and California, for instance, levy an income tax each year on the appreciated value, just as the federal government does with Treasury zeros. Other states, including Massachusetts and Pennsylvania, exact a tax only when income is actually received. Investors should buy bonds with solid credit ratings. Since the big payoff from zeros comes in the later years, the health of the issuer is paramount. Muni bond analysts at Shearson Lehman rate all the bonds shown in the table as safe bets, and tempting values as well. Most brokers require a minimum purchase of five bonds, whose face value in each case is $5,000. But because the bonds sell for mere fractions of the maturity value, investors well off enough to be interested in muni zeros can afford to ante up.

CHART: BOND RECENT EFFECTIVE EARLIEST DEBT RATINGS PRICE YIELD CALL DATE MOODY'S/S&P Harris County, Texas 10.375% due 8/1/2000 $1,179.25 9.60% non-callable Aaa/AAA State of Michigan 10.25% due 5/1/2011 $343.95 10.50% 5/1/2000 A/A+ New York State Mortgage Agency 10% due 10/1/2014 $271.30 10.10% 4/1/1993 (1) Aa (2) Jacksonville Electric Authority 10.25% due 10/1/2014 $229.20 10.70% 10/1/1994 A1/AA City of Tallahassee 10.70% due 10/1/2004 $706.80 10.25% 10/1/1994 Aaa/AAA (1)Subject to mortgage prepayment. (2)Rated only by Moody's.