Dear Dr. Don,
Is it ever a good idea to put money in zero-coupon bonds?
— Ellen Goose-Egg
I own some municipal zeros, so I certainly hope so! In fact they’ve been a great investment for me, but I bought them almost 10 years ago. You have to make your investment decisions based on today’s markets and rates.
Coupon bonds typically pay interest semiannually based on the bond’s coupon rate. A $1,000 bond paying 6 percent semiannually will pay $30 every six months from the date of issuance until the bond matures.
However, a zero-coupon bond doesn’t pay interest until it matures. Because no interest is paid but interest is earned, the bond sells at a discount to its stated face value.
A Treasury bill is a form of zero-coupon security. No interest payments are made. The bill sells at a discount to its face value up to the day it matures. At maturity, the investor receives the face value of the bill. The interest earned is the difference between the price paid for the security and the price received at maturity.
Treasury strips are longer-maturity zero-coupon bonds with maturities out to 30 years. There are corporate zeros, government agency zeros and municipal zeros, too. I don’t know enough about your financial picture or tolerance for risk to make a recommendation, but zero-coupon securities don’t need to be ruled out unless you need the interim income from a coupon paying security.
One of the great things about zero-coupon bonds is that you don’t have to worry about reinvestment risk like you do with a bond with coupon payments. Where are you going to invest a $30 coupon payment? Probably in a checking, savings, or money market account or money market fund earning a lot less than the coupon interest rate on the bond.