Advantages and Risks of Zero Coupon Treasury Bonds

Zero-coupon bonds are bonds that do not make any interest payments (which investment professionals often refer to as the “coupon”) until maturity. This means that if you buy today a zero-coupon bond that matures in 20 years, you won’t put a single penny worth of interest income in your pocket for two decades. For some investors, that proposition has a strong appeal.

Zero-coupon bonds come in many varieties. They may be issued by federal, state or local governments or by corporations. Perhaps the version most familiar to many investors is the old Series EE savings bonds issued by the U.S. Treasury that were often given as gifts to small children. These bonds were popular because they could be purchased in small denominations. For example, a $50 bond could be purchased for $25. The child would keep the bond for several decades and then, when it matured, received $50. While the terms of the savings bond program has changed, and bonds are only available in electronic form, they still exist – and are still a valid example of how zero-coupon bonds work.

Some zero-coupon bonds are issued by corporations. In a twist on these offerings, some zero-coupon corporate bonds can be converted into shares of stock in the issuing company. These bonds are called “convertibles." Zero-coupon bonds can also be created by banks and brokerage firms. These entities take a regular bond and remove the coupon to create a pair of new securities. This process, often referred to as “stripping” (as the coupon is stripped away from the debt instrument), results in a zero-coupon bond that can be sold to investors; the future interest payments can also be sold to investors.

Why would anyone want a bond without the interest? Well, for one thing, zero-coupon bonds are bought for a fraction of face value. For example, a $20,000 bond can be bought for far less than half of that amount.

Then there are the tax exemptions. If issued by a government entity, the interest generated by a zero-coupon bond is often exempt from federal income tax, and often from state and local income taxes too. Various local municipalities are significant issuers of zero-coupon bonds as they seek to raise capital to support infrastructure and other projects; some of these bonds are triple tax-free, with the income they generate exempt from income tax at the federal, state and local levels. In either case, paying less in taxes is always good news, because it puts a greater percentage of the earnings generated into investors' pockets instead of Uncle Sam's.

Interest income from corporate zeroes is taxable, however, and unfortunately investors must pay income tax on it each year, even though they won't receive the earnings until the bonds mature. For this reason, zero-coupon bonds issued by corporations are often purchased in tax-deferred plans  such as Individual Retirement Accounts (which postpones the tax liability). As additional compensation, the interest rate corporate zeroes offer is likely to be higher than the rate offered on a tax-free bond of similar maturity and credit quality.

If you are retired and looking to generate a current, steady stream of income, zero-coupon bonds are probably not high on your list of potential investments. On the other hand, if you need a specific amount of income on a specific date in the future, they may be the perfect choice. Consider, for example, funding college for your offspring. If your goal is to help the child pay for an education, it is fairly easy to predict the year in which he or she will start needing the money. Purchasing zero-coupon bonds that mature at that time can be a convenient way to help cover the expense.

Zero-coupon bonds are also appealing for investors who wish to pass wealth on to their heirs but are concerned about income tax or gift taxes. If a zero-coupon bond is purchased for $1,000 and given away as a gift, the gift giver will have used only $1,000 of his or her yearly gift tax exclusion. The recipient, on the other hand, will receive significantly more than $1,000 when the bond matures. Similarly, tax-free zero-coupon bonds make good gifts for children who generate more than $1,800 in annual income and are subject to taxation on earnings. The bonds will provide income for the children without increasing their tax liabilities.

Zero-coupon bonds are also an interesting option for investors with little interest in watching the financial markets move up and down. You just buy the bond and wait for it to mature. It’s a simple way to implement a “set it and forget it” investment strategy.

Zero-coupon bonds may not reach maturity for decades, so it is important to make sure that any bonds purchased have been issued by creditworthy entities. Some of them are issued with provisions that permit them to be paid out (called) before maturity. Investors counting on a specific payout on a specific date should be aware of these provisions to avoid the implications of what professional investors refer to as "call risk."

Also, the bonds' daily prices fluctuate on the open markets, so investors who sell them prior to maturity may receive more or less money than they originally paid. It can be a wild ride: Because they do not pay any periodic interest during their duration, zero-coupon bonds tend to be more volatile than their conventional counterparts. (See "Why Do Interest Rates Tend to Have an Inverse Relationship With Bond Prices?" for details.) Of course, if held until maturity, the payout will be predetermined and does not change.

Zero-coupon bonds issued by the federal government can be purchased directly from the Treasury at the time they are issued. After their initial offering, they can be purchased on the open market through a brokerage account, just like other bonds. Other types of zero-coupon bonds can also be purchased using a brokerage account.

Of course, a little bit of personal due diligence is always a good idea. To get familiar with the marketplace, just go to your favorite search engine and look for “taxable tax-exempt yield equivalent 2018” to find websites that let you compare the yields offered by tax-exempt bonds with the yields offered by their taxable peers. This information will provide some insight into the value of the tax deferral, and it may help you narrow down the field of potential investments.

Like most investment vehicles, zero-coupon bonds are like tools in a toolbox. Picking the right tool for the job can help you achieve your objective. A little time and effort, to make sure you understand the investment and have made the right choice for your needs, can go a long way toward helping you feel comfortable and confident enough to wait many years (or decades) for your investment to mature and pay out – with interest.