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Utilizing Zero Coupon Bonds in Financial Planning

Tuesday, Oct 20, 2015

Zero coupon bonds offer long-term investors a rare investment opportunity. When used correctly, they can act as a relatively stable, predictable, and potentially beneficial investment vehicle. They are often added to investment portfolios when foreknowledge of the exact timing and return of an investment is important, such as when planning for retirement, saving for a child’s education, or preparing for the expense of an elderly parent.

Zero coupon bonds can be divided into three categories, depending on the issuer – zero coupon treasury bonds, zero coupon municipal bonds, and zero coupon corporate bonds. Each type shares the basic characteristics of these highly unique investments, but they all have their own specific traits.

How Zero Coupon Bonds Work

The periodic interest that a typical bond pays out is known as a coupon. Zero coupon bonds, whether treasury, municipal, or corporate, have no coupon, meaning that investors receive no periodic interest payments during the lifetime of the investment. Instead, the bonds are purchased at a significant discount. When they reach maturity, the investor receives the full face value, as well as all the compounded interest earned over the years.

This usually translates into a discounted original purchase price, years or decades of holding onto an investment, and then a substantial payout at a set date. There are obvious advantages to this, particularly for investors who are interested in capital accumulation.

All zero coupon bonds:

  • Are purchased at a significant discount
  • Come with a stated yield, which is paid out along with the par value at maturity
  • Tend to have higher interest rates than other bonds in order to attract investors
  • Are suitable for long-term investors seeking capital accumulation

The Varying Levels of Risk

Depending on the type of issuer, zero coupon bonds can differ in terms of risk. Zero coupon treasury bonds are considered the safest investments, though many zero coupon municipal bonds also come with a low level of risk. Because they are debt obligations issued by states, cities, and other government entities, municipal bonds as an asset class historically have a relatively low level of default.

Zero coupon corporate bonds may come with the highest rates, but they can also be the riskiest. If a company does not set the interest payments aside for the future, or simply cannot survive through the ups and downs of the business cycle for two or three decades, then a default is possible. Investors should be confident in a corporation's future stability and level of financial responsibility when investing in these bonds. It is also important to note that corporate bonds can be called early, leaving the investor open to call risk.

Key Differences: Taxes

Besides the varying levels of risk, taxes play a role in differentiating the types of zero coupon bonds. Zero coupon treasury and corporate bonds are not tax-free, but rather, come with what is known as the phantom tax. This means that taxes must be paid on interest that is earned each year, even though the investor does not see this return until maturity.

Zero coupon municipal bonds accrue tax-free interest. This is what makes zero coupon bonds issued from municipalities a highly valued and unique investment vehicle, especially for investors with particular financial planning needs. The tax-free advantages, as well as the low risk and predictable future income, make these bonds an optimal long-term asset. While the interest earned is federally tax-free, interest may be subject to state and local taxes. Capital gains, if any, are also subject to tax.

Find out more about how zero coupon municipal bonds can help you meet your financial goals. Speak with one of the municipal bond specialists at The GMS Group to learn more – contact us or call 877-567-9811.