Zero-bond, my hero
They're unexciting, unsexy and have a big zero in their name, but they work
NEW YORK (CNNfn) - Most investors shy away from anything with "zero" in its name. A sure sign of a loser, they think. But zero-coupon bonds have proven themselves to be a lot more lucrative than their name would suggest.
Zero-bonds' reputation received a further blow last week when mogul Warren Buffett's Berkshire Hathaway announced it sold off all of its U.S. government long-term zeros.
Zero-bonds' name has nothing to do with a propensity for returning zip to their holders. For many years, coupons were attached to the bond which was given to buyers. Bondholders would then clip out one of the coupons and take it to the issuer to receive their interest payment.
Zero-coupon bonds didn't offer regular interest payments while the owner was holding it. No interest, no coupons.
Zero-coupons are still quite unknown to many American investors and a closer look might convince them zeroes are heroes.
"Zeroes are the best-kept secrets on Wall Street," said Skip Morton, director of fixed-income marketing at Tucker-Anthony. "It always amazes me that people don't know what they are."
Many traditional bonds, such as U.S. Treasurys, are purchased at face value, say $1,000, with a specified maturity. As interest rates rise or fall, the overall return on these bonds fluctuates, making them either a good investment, a wash, or somewhere in between.
Zero-coupons take the uncertainty out of this. When you buy a zero, you pay a deep discount on the bond's face value. For instance, you may pay $600 for a zero-coupon that has a face value of $1,000.
However, zero-coupon bonds don't pay interest in the same way with which most investors are familiar. A $1,000 zero purchased at $600 will, upon maturity, bring $1,000, or $400 in interest.
Additionally, you won't be receiving interest payments during the time you hold it.
The certainty of these bonds is what lures investors, explained William Horanbargar, fixed income strategist at A.G. Edwards in St. Louis, Mo.
"You're locked into a true return," he said.
For this reason zero-coupons aren't for people who need a set income, but rather want to use them to pay for a specific need in the future, whether a house, a child's college education or retirement.
The cost of zeroes
If the assured payoff of zero-coupon bonds appeals to you, you'll need to go to a broker to purchase one, but you should shop around.
All brokers pay the same price for these bonds. However, their markups (the charge they add onto the price) vary. Since the only money you'll be making on this bond will be the difference between your purchase price and the face value, the more you pay, the less your yield.
There isn't just one type of zero-coupon bond. The two main categories are U.S. Treasury zeroes, issued and backed by the federal government, and municipal zeroes, issued by state and local governments, with other variations bouncing around.
The tax implications between the two are important and need to be considered before you make any purchases.
When you buy a zero-coupon bond, you won't be receiving any interim interest payments. However, during the time you hold it, the government considers you to still be making interest on it.
"You pay taxes on the accreted value even though you don't get the benefit until maturity," said Horanbargar. "The longer you own the bond, the greater the liability becomes."
The increasing tax burden is because as your zero is accumulating "interest," and nearing maturity, its overall value is increasing, at least in the eyes of the IRS.
You can head some of this problem off by buying your zeroes selectively. Most municipal bonds are exempt from state taxes provided you've bought them in the same state that issued them.
Since this is true, you might wonder why anybody would buy the U.S. Treasury zero-coupons but many people who are saving for their retirement crave the security of knowing money saved up for a lifetime will be backed by the federal government.
Even those who buy Treasury zeroes can do a two-step around the tax problem. U.S. government zeroes can be bought for a tax-deferred investment like an IRA. You won't pay the taxes on it until you retire, a time when many people are in a lower tax bracket, minimizing the hit you'll take.
Tucker-Anthony's Morton advises using a combination of the two types of zeroes to get the best of both worlds.
On top of all the other investments you may have -- stocks, funds, bonds -- you can shrewdly use a technique known as "laddering" to squeeze more out of your zero strategy.
Using laddering, you would buy zeros with varying maturities after your projected retirement date. For example, if you're 55 and planning to retire at 65, you would buy zeroes due 10 years from now, 11 years and so on.
Upon retirement, said Morton, you'll be getting a steady stream of maturing zero bonds "and the further out I buy, the cheaper they are." So, a 10-year $1,000 zero-coupon bond may cost you $600 while an 15-year zero may cost you $450.
You'll only want to buy a zero-coupon bond if you're prepared to stick with it. Zeroes face a very different market than their traditional bond cousins.
The most typical bond, the 30-year Treasury, offers regular interest payments, making it more desired. Since zeroes don't offer this, the market for them is very volatile. Selling them for a gain before maturity is a job for the pros. Most individual investors probably aren't nimble enough to do this effectively.
Zeroes have other potential pitfalls. Zeroes are subject to "calls," where the entity that issued the bond has the right to buy it back, although these calls are generally more favorable to the investor than they are with other types of debt securities.
Overall, though, zero-coupon bonds provide a safe and effective way to get a solid investment return. Still, said Morton, they may still struggle along to gain acceptance.
"They're not exciting. They don't give you the gambling rush that stocks do. They're not glamorous things but they're not risky things either."
-- by staff writer Randall J. Schultz