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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:

  • U.S. Treasury STRIPS

  • U.S. Government Agency Zeros

  • Eagle Traders Market

  • Corporate Zeros

  • Zero-Coupon CDs

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