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Negotiable
Financial Instruments > This
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Fixed Income - Zero Coupon
Instruments
(Source: Merrill Lynch)
A
safe and reliable investment
If you are seeking a safe, reliable investment that provides attractive,
predictable returns, zero coupon instruments can be an ideal solution.
Their many advantages include the following:
-
Assured growth, assuming
you hold the securities until maturity.
-
Low minimum investment
-
Automatic compounding of
interest.
-
A wide selection of issuers,
and maturities ranging from one year to 30 years or more.
-
Liquidity through a secondary
market
How
zero coupon instruments work
Zero-coupon instruments do not make periodic interest payments. Instead,
the interest accrues and is paid in a lump sum at maturity. You buy zero
coupon instruments at substantial discounts to their par value (face value)
at maturity.
When each instrument matures,
you receive its par value, which represents your original principal investment
and the compound interest you earned but did not receive during the life
of the instrument.
Generally, the further away
the maturity date, the lower the purchase price as a percentage of that
future value. The value of a zero coupon instrument increases as the maturity
date approaches, eventually reaching par value at maturity.
Ideal
for long-term financial planning
Zero coupon instruments, which were introduced in the early 1980s, have
grown steadily in popularity among investors who do not need current income
but want a conservative investment that offers an assured return on a
specific future date. Zero coupon instruments are ideal for this purpose.
You can select maturity dates that match the time you will need the money
- perhaps for a home purchase, your child's education or your retirement
- and know precisely how much money you will receive.
No
reinvestment risk
Zero coupon instruments eliminate the reinvestment risk normally associated
with traditional coupon-bearing bonds. If interest rates decline after
you invest in a coupon-bearing bond and you reinvest your interest payments
at lower rates than the original investment yield, your total effective
yield, over time, will be lower. In addition, if you are investing relatively
small interest payments, your choices for reinvestment will be limited.
The semiannual interest payment on a $1,000 bond with a 7% coupon, for
example, would be only $35.
With zero coupon instruments,
you don't need to worry about reinvesting periodic interest payments at
a lower rate because the interest automatically compounds over the life
of the instrument. You lock in a true compound rate of interest for the
entire period. The trade-off is you don't get the benefit of being able
to reinvest interest payments at a higher rate, in the event that interest
rates rise after your date of purchase.
Zero
coupon instruments recommended are:
Tax
considerations for U.S. investors
A portion of a zero coupon instrument's discount from face value
- that is, the imputed interest - is taxable as ordinary income each year,
even though you don't receive the cash payment until maturity. That's
why zero coupon investments are best suited for tax-advantaged accounts,
such as individual retirement accounts (IRAs), Basic (Keogh Plus) plans
and custodial accounts for minor children.
Market
value considerations
While the future of zero coupon instruments, if held to maturity, is fixed
and will not change, their market values vary with interest-rate changes
prior to maturity, just like all fixed-income securities. Further to the
above, zero coupon instruments fluctuate more sharply in price than do
conventional coupon bonds:
-
When interest rates rise,
the market value of zero coupon instruments tends to fall more than
the value of coupon issues.
-
When interest rates decline,
the market value of zero coupon instruments tends to rise more than
the value of coupon issues.
The longer the instrument's
maturity, the greater the price fluctuations will be.
Recommended further reading:
Zero-Coupon
Instruments
Zero Coupons and STRIPS
Advantages of Convertible Securities
Books on Financial
Instruments
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