(MONEY Magazine) – Imagine an investment that produces wide swings in value in the course of a week or even a day but at the same time lets you lock in a predictable rate of return. This seemingly paradoxical investment is a zero-coupon bond -- a relatively new security with appeal to conservative investors saving for retirement, parents putting money away for their children's college education as well as for speculators seeking quick profits by gambling on interest-rate movements. The locked-in rates of zeros are especially attractive now, because many economists expect interest rates to fall sharply in upcoming years. Zeros, so named because they pay bondholders no interest until maturity, are sold individually by stockbrokers and through mutual funds with portfolios that will mature around the same time. There are zero versions of Treasury, government agency, corporate and municipal bonds (see the box at right). Their chief appeals: -- A high, guaranteed return if held until maturity. Some 30-year taxable zeros now yield 10%; muni zeros offer as much as 8%. -- A low price that is a fraction of the bond's typical $1,000 face value. Their premier flaw: you could take a bath by selling the zero bonds early -- unloading a zero before it comes due after a one-point rise in interest rates might mean accepting a double-digit loss. If interest rates fall, however, bond prices will go up, so you could also profit by selling before maturity. Zero-coupon bonds first became widely available in 1981, when Merrill Lynch split U.S. Treasury bonds into their two components -- principal and interest coupons -- and sold them separately. When you buy a zero, you actually own a bond's interest coupon, reissued as a new security, that will be paid out in a lump sum at maturity. That means there are no semiannual interest payments, as there are with other bonds. The bond's maturity date could be in a few months or as long as 30 years hence. As the chart at left shows, the further away the bond's maturity date, the bigger its discount from face value and thus the lower your purchase price. Keep in mind that even though a zero does not distribute income until you cash it in, the Internal Revenue Service and some states require you to pay income taxes annually on the interest the bond has accrued during the year. Two exceptions: municipal zeros and those held in tax-deferred plans such as Individual Retirement Accounts and Keoghs. Your stockbroker or zero-coupon bond fund will send you a form listing the amount on which taxes are due. Zeros do eliminate a drawback of conventional bonds known as reinvestment risk. If you hold a standard bond and rates fall, you will be stuck with a lower rate when you reinvest the bond's income. Zero-coupon investors avoid this uncertainty since they get their interest only by cashing in their bonds. This lack of reinvestment risk, however, also contributes to a zero's jittery price movements. As interest rates drop, an investor will pay more for a zero with its locked-in rate than for another bond, so the zero price goes up. But when rates rise, the zero's lower rate makes the bond less enticing to investors, and its price sinks. For example, a one-percentage-point rise in interest rates today would cause a 15% decline in the price of a U.S. Treasury zero bond maturing in 2005. A comparable conventional government bond would suffer only a 7.8% decline.

CHOOSING THE BEST BONDS How much you will shell out for a zero is hard to determine -- but pivotal. Brokerage firms buy zeros wholesale and resell them to investors at retail prices reflecting their cost of holding the securities in inventory plus a profit. This markup, assessed in lieu of a sales commission, increases the price you pay for zeros and reduces the price you get if you sell. The markup varies widely, but brokers may -- and should -- tell you what it is. Charles Schwab & Co., for example, imposes a fair charge of $5 per bond or 1% of the bond's face value, whichever is less, with a $39 minimum. Many brokerage firms provide far less clarity, simply telling investors the prices of their zeros and refusing to disclose markups. The best way to avoid overpaying is by comparison shopping among several full-service and discount brokers. Ask each how much you must invest for the zero you want, how much your investment will be worth in dollars at maturity and the effective yield to maturity. The broker with the lowest figure for the first question and the highest for the latter two is offering the best deal. Be sure to ask also whether the bond is callable, which means that its issuer can redeem the security before its due date if, say, market interest rates have declined. If the zero can be called, ask for both its yield to maturity and its yield to call -- your guaranteed return if the bond must be redeemed early. Try to buy only non-callable zeros for their guaranteed yields. When considering corporate or municipal zeros, it is essential to review the financial stability of their issuers. Even when you hold a corporate or muni zero to maturity, your return is certain only if the issuer has the wherewithal to pay its debt. Moreover, you could have a tough time selling one of these zeros in the face of bad news about its company or municipality because the market for the bonds is relatively small. In general, the safest are the ones triple-A rated by Moody's or Standard & Poor's. If you prefer the certainty of Treasuries, there is also the option of no- load mutual funds called targets that buy Treasury zeros set to mature in a given year. Benham Capital Management (800-227-8380; in California, 800-982-6150; minimum investment $1,000) markets six funds with portfolios maturing in five-year increments from 1990 to 2015. Scudder (800-225-2470; minimum investment $1,000) offers target dates of 1990, 1995 and 2000. In December of the target year, the funds liquidate and investors get their share of the bonds' payouts. Before investing, call the fund for a figure representing the expected value of your investment if held to maturity.

SELLING YOUR FUND SHARES You can redeem these fund shares any time at their current market value -- but at your peril. Zeros are the most volatile of all bond funds. In fact, the Benham Target 2015 Fund was the worst-performing bond fund in the third quarter of 1987 (down 22.9%) when interest rates rose but the best performer a quarter later (up 25.9%) after rates fell. , Zero fund sponsors eliminate markups by buying bonds at wholesale prices, but investors do pay annual fees for management and other fund expenses -- 0.7% at Benham and 0.6% at Scudder. So if you are certain you will hold the bonds to maturity, individual Treasury zeros will generally give you a higher return than funds, after expenses. For instance, $1,000 invested in 2005 Treasuries purchased through Kidder Peabody in early July would be worth $4,614 at maturity, while the same amount invested in Benham's Target 2005 Fund would be worth approximately $4,168 -- $446 less.

BOX: At a Glance A buyer's guide to zeros

Zeros come in many permutations, all sold by full-service and discount stockbrokers. Even Treasury zeros cannot be bought directly from Federal Reserve Banks but are marketed by brokers -- generally under catchy if confusing acronyms like CATS or STRIPS. With most zeros, the longer their maturity, the higher their yield and the lower their purchase price (see the chart above). Currently, however, yields start dropping along with prices after 2010 or so. The analysis below lists zeros from the safest to the riskiest. Be sure to find the lowest broker markup, because at the wrong price, even the soundest CATS are dogs.

TREASURIES

STRIPS Currently yielding: 7.3% to 9.5% Price: $976 to $138.30 Easiest zeros to unload in a hurry

TIGRs, CATS, LIONS Currently yielding: 7.6% to 9.6% Price: $976.10 to $136.30 Yield more than STRIPS because banks holding the bonds in escrow might be slow providing your eventual interest payout

GOVERNMENT AGENCIES Currently yielding: 8.1% to 10% Price: $965.20 to $123.30 Issuers range from the Tennessee Valley Authority to the Student Loan Marketing Association (Sallie Mae)

CORPORATES Currently yielding: 8.8% to 10% Price: $721 to $260 Even higher yields are available from convertible zeros, whose issuers can later turn them into callable zeros or, alternatively, bonds that pay regular periodic interest

MUNICIPALS Currently yielding: 6.4% to 8% Price: $660 to $130 The only zeros exempt from federal (and often state and local) income taxes, they deliver higher after-tax yields than other zeros if you are in the 28% or 33% brackets (taxable income of at least $29,750 if married and filing jointly or $17,850 if single) )

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Typical $1,000 zeros As maturity lengthens in zeros, prices fall and yields rise. DESCRIPTION: Comparison of zero-coupon bonds.