How to Invest in Zero Coupon Bonds
July 19, 2018
Zero-coupon bonds live in the investing weeds, easily ignored by ordinary investors seeking growth for college and retirement. Even fixed-income investors may pass them by, because they don't provide regular coupon payments – the interest earnings come all at once when the bond matures.
But the fact that they exist suggests they are useful to someone. Should ordinary investors take a look? How do they tend to do in times like these, with a strong economy but the threat of rising interest rates, which typically undermine interest-earning investments?
Because of that interest-rate risk, ordinary investors are probably wise to stay away for the time being, says Robert R. Johnson, principal at the Fed Policy Investment Research Group in Charlottesville, Virginia.
Zeros are purchased through a broker with access to the bond markets, or with an actively managed mutual fund or and index-style product like an exchange-traded fund.
"The idea of owning a zero makes sense when you have a target date in mind like college savings or retirement," says Travis T. Sickle, a financial planner in Tampa, Florida. "But once you look at the rates you realize they're not that great right now." – Jeff Brown
See why income investors consider zero coupon bonds for their portfolio.
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https://money.usnews.com/investing/bonds/articles/2018-07-16/how-to-invest-in-zero-coupon-bonds
As it points out, zeros include those issued by a government:
"Like all bonds, zeros are loans from the bond purchaser to the company or governmental body that issued the bond."
If you want to buy zeros issued by the US government, you can buy them directly from the Treasury through TreasuryDirect. I've suggested using 3 or 6 month zeros instead of comparable CDs. Similar yield, better safety (full faith and credit of the US government), and state income tax-free, making the after tax yield even better.
Regards,
Ted
https://www.investopedia.com/ask/answers/06/zerocouponregularbond.asp
But I do know they are better left in the hands of experienced traders. Suspect they serve as “hedges” in some professional portfolios because a relatively small investment in them can yield a big “bang” under certain conditions - perhaps during a stock market rout. They’d also make a handy “short” in the hands of a skilled trader.
I owned them years ago (actually decades ago) in funds at American Century. Seems to me they were called “Target Maturities”. They held stripped U. S. Treasuries and offered one wild ride. (The farther out the maturity date the wilder the ride.) Seems to me AC phased those funds out or is in the process of doing so.
I just prefer not to say. It will open a can of worms.
If you buy a 1 year zero paying 2%, you'll pay about $98 for a bond returning $100 in a year.
Technically, it will cost $100/(1 + 2%) = $98.04, but $98 is close enough.
If the rates jump to 3%, you could sell that bond for only about $97.
Technically $100/(1 + 3%) = $97.09. That's about a 1% drop in price.
That's the way zeros work. duration = maturity.
(Try the same arithmetic with a two year bond - at 2% the price will be about $96, and at 3% it will be around $94.)
If you buy a bond that has a 2% coupon, paying twice a year, and market rates are 2%, you will pay (approximately) $100 for that bond.
You'll get $1 in six months, and $101 ($1 interest and $100 principal) in a year. Ignoring compound interest, that's a 2% yield.
So this coupon bond is really a combo of two zero bonds:
- a $1 bond maturing in six months
- a $101 bond maturing in a year
The shorter (six month) bond drops only 1/2% in price when rates go up 1%. So the average drop in price of the combo is less than a full 1%. The more coupon payments you expect before maturity, the more those payments help reduce the volatility of the bond.