How to Invest in Zero-Coupon Bonds

Experts say zeros are useful for investors with a predictable future need, such as paying for college or retirement. (Getty Images)

Zero-coupon bonds live in the investing weeds, easily ignored by ordinary investors seeking growth for college and retirement. Even fixed-income investors may pass them by, because they don’t provide regular coupon payments – the interest earnings come all at once when the bond matures.

But the fact that they exist suggests they are useful to someone. Should ordinary investors take a look? How do they tend to do in times like these, with a strong economy but the threat of rising interest rates, which typically undermine interest-earning investments?

Because of that interest-rate risk, ordinary investors are probably wise to stay away for the time being, says Robert R. Johnson, principal at the Fed Policy Investment Research Group in Charlottesville, Virginia.

Zeros, he says “are one of the worst-performing classes of securities during a rising-rate environment.”

Zeros are purchased through a broker with access to the bond markets, or with an actively managed mutual fund or and index-style product like an exchange-traded fund.

PIMCO 25+ Year Zero Coupon US Treasury ETF (ticker: ZROZ), an exchange-traded fund containing zeros with long maturities, yields about 2.7 percent. While that’s not terrible compared to many safe interest earning funds, it’s probably not enough to compensate for the high risk. The fund has a “duration” of about 27 years, meaning it could lose 27 percent of its value for every one percentage point rise in prevailing interest rates.

“The idea of owning a zero makes sense when you have a target date in mind like college savings or retirement,” says Travis T. Sickle, a financial planner in Tampa, Florida. “But once you look at the rates you realize they’re not that great right now.”

Like all bonds, zeros are loans from the bond purchaser to the company or governmental body that issued the bond. With most bonds, the owner receives regular interest payments and then gets back the principal, or face value, when the bond matures. A 10-year bond typically pays more than a one-year bond, because investors demand more for tying their money up longer.

Zeros, instead of paying interest, are sold at a deep discount and then redeemed at maturity for the face value. That’s fine if the investor doesn’t need regular income, and it can be appealing if the discount is big enough to compensate for the delayed payoff. But there are some wrinkles to consider.

One issue is phantom income. For tax purposes, the bond is treated as if the imputed interest is in fact paid every year. The investor is therefore taxed on income that has not yet been received and must dig into other resources to pay. The problem can be avoided with a tax-free municipal zero-coupon bond, or by holding the zero in a tax-preferred account like an individual retirement account.

Volatility is a second issue. Interest-earning investments tend to lose value when prevailing interest rates rise, because investors prefer newer securities that pay more. And they gain value when rates fall, because they are more generous than newer issues. The longer the bond has to maturity, the wider the price swings, as investors will suffer or benefit for much longer.

This effect is even stronger for zeros because there is no immediate income. In contrast, if rates have fallen, income on an older ordinary bond looks particularly generous. If rates rise, ordinary bond income can be reinvested at the higher rates, dampening the price drop. Since zeros don’t have these cushions, they tend to be volatile, an additional risk if the investor may need to sell the bond before it matures.

What type of investor can benefit from this peculiar arrangement?

One group: those who want predictable returns.

Since there are no annual interest earnings, the investor does not risk having to reinvest interest earnings after rates have fallen. The investor who can hold the bond to maturity therefore knows exactly what it will return, Johnson says.

“Consequentially, zero-coupon bonds are especially appropriate when investors wish to lock in a rate of return and be assured of a specific accumulation at a given future date,” he says.

Experts say this makes zeros useful for investors with a predictable future need, such as paying for college or retirement. Obviously, the investor must be capable of forgoing immediate interest earnings in return for the big payoff at the end.

“If the goal is to have a specific amount of money in a specific number of years from now, short-term debt is very risky and carries significant interest rate and re-investment risk, and a zero-coupon bond is a great solution, says Michael Tanney, co-founder of New York City-based Wanderlust Wealth Management.

The investor also must be able to weather the ups and downs along the way as prevailing rates rise and fall. Those with the stomach for speculation can bet that rates will fall and drive the bond’s price up – possibly higher than the face value.

Today, that’s quite a gamble, since rates have been rising, and the Federal Reserve is expected to keep pushing them up to head off inflation as the economy heats up.

“Zero-coupon bonds perform worse than traditional coupon paying bonds in a rising interest rate environment due to their longer duration,” says John Linton, of Elbert Capital Management in Denver. “Effectively, the price of a zero-coupon bond has to decrease more than a traditional coupon bond to adjust to a new higher interest rate.”

Johnson says the overwhelming consensus of the market is interest rates are much more likely to move up in the foreseeable future.

“The consensus of the market is that the Fed will raise rates 25 basis points at the September meeting and another 25 basis points at the December meeting,” he says. “An increase of 50 basis points would negatively impact zero coupon bond values – and, would significantly negatively impact zero coupon bonds with longer maturities.”

Of course, an investor with a yen for risk could bet on a big surprise driving rates down.

“The potential surprise – and one that would benefit purchasers of zero-coupon bonds – is that the U.S. gets into long and protracted trade war and the economy slows,” Johnson says. “This would likely cause the Fed to reverse the path of interest rate hikes.”

For now, zero-coupon bonds are something the ordinary investor should know about. But acting on that knowledge should wait for better conditions.

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