Exercise Caution with Zero Coupon Bonds

Zero coupon bonds are an interestingderivative investment, but notnecessarily a great investment forlong-term investors. We think of bondsas having two parts, an income streamusually payable every 6 months, and aprincipal value payable on maturity. Ifwe could divide them into two parts,then some investors might prefer anincome stream with no principal repayment,and other investors might preferonly the principal repayment. So, a largeinstitution buys a few hundred milliondollars of 30-year Treasury bonds, holdsthem as the custodian, and sells rights tothe two parts to different investors.

Significant Risk

A Treasury zero (sometimes called astrip) is very high-risk. Even though theseare backed by a US government bond,they fluctuate much more than a regularbond because they don't have the couponpayment to stabilize them.

As it turns out, the principal value is asmall part of the total value of a bond.Interest payments are a far more valuablecomponent. The market value of the zerois the face amount discounted back to apresent value using the current interestrates. For instance, if you had a new$10,000 30-year Treasury bond at 7%, thevalue of the principal would be only$1313.67. The balance of $8686.33 is thevalue of the interest payments.

Very small interest rate changes willwhipsaw the principal value of the bond.The longer the time to maturity, the moreextreme the fluctuations become. Forinstance, if interest rates rise 1% on our30-year 7% zero, then the market valuedrops about 24%, to $993.77. These extremechanges in value make the zero anattractive tool for speculators, but notvery attractive to long-term investors. In arising interest rate environment, zeros area suicide pact. An economist would callzero coupon bonds an inefficient investmentbecause they have a high level ofrisk compared to their expected return.

Phantom Income

If you hold zero coupon bonds in a taxableaccount, you will have another interestingproblem. You must pay income tax,at ordinary rates, on the theoreticalincrease in value each year. However, thebond doesn't throw off any cash flow. Youwill have to dip into your other funds topay the tax. Even worse, you will pay thetax even if the value of the bond has gonedown. This strange tax treatment is sometimesreferred to as phantom income. TheIRS adopted it to prevent taxpayers fromrealizing capital gains on the appreciationof an asset that should normally produceordinary income. Of course, the tax reducesthe nominal yield.

Primarily as a result of the principalrisk, zero coupon bonds are not recommendedas a substitute for cash or short-termbonds. After all, this is the part of theportfolio that we count on to be availablefor emergencies and to produce incomeregardless of the current state of the marketor level of interest rates.

The Informed Investor: A Hype-

Free Guide to Constructing a Sound Financial

Portfolio

Frank Armstrong III, CFP®, AIF,is the founder and principal ofInvestor Solutions, Inc, a feeonly,SEC-registered investmentadvisor. He is also the author of(Amacom; 2002), which is now availablein paperback. For more information, visitwww.investorsolutions.com.