Strategic Considerations of Zero Coupon Securities

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Strategic Considerations of Zero Coupon Securities

Zero coupon bonds share many of the characteristics of other types of bonds, with one important exception. Since they do not feature regular interest payments, they are not an income investment, as other bonds are, but should be considered an appreciation investment.

The tax implications

It is important to remember, however, that unlike the growth in value of a stock portfolio or mutual fund, the appreciating value of a zero is really a representation of accrued compound interest, and is taxed as such—not as capital gains, which are taxed at lower rates. There are, however, a variety of tax-free government zeros available. Zeros can also be suitable in an IRA or other tax-deferred or tax-free plan since they make no distinction between capital gains and ordinary income for tax purposes.

Risk factors

Since zeros are debt instruments, the risk involved depends largely on the credit strength of the issuer. Zeros backed by government securities like US Treasury bonds have very low credit risk, while corporate zeros can be much riskier. If the issuer does default, you may be out quite a bit, because you have not received any interest payments. Also, as with other bonds, the real values of zeros depend on how the returns compare with prevailing interest rates—a factor that makes zeros quite volatile on the secondary market. As a result, most investors hold zeros to maturity.