This blog is going to be another short and ‘sweet’ one. I just completed my taxes and I am starting to work on my oldest son’s college financial documents this week. I will have limited time to work on my blog and will continue to write some short blogs on bonds investing. Today I’ll talk about zero coupon bonds.
Last blog (dated February 28th) I talked about zero coupon bonds and average bond duration. Zero coupon bonds are the only type of bonds for which maturity equals the duration. For example if the zero coupon bond maturity is 10 years the duration will be 10 years. What are bond coupons and zero coupon bonds? The term bond coupons came about when bonds were historically issued as bearer certificates - if you had possession of the certificate, you were considered the owner of the bond. Coupons were attached to the bond, for example if the bond maturity was 10 years and the interest was paid once a year you would have ten coupons for each interest payment. At the due date you would cut the coupon from the bond and present it for payment. Zero coupon bonds have no coupons; you buy the bond for less than the face value and get repaid the face value at time of maturity. There are no yearly interest payments. For example, if you paid $750 for a bond that has a face value of $1000 and maturity of 5 years, you will be paid $1000 after five years.
Zero coupon bonds have interesting US tax consequences. Even if the bond holder does not get interest payments every year the IRS requires you that you “impute” an interest income every year and report this income every year on your income tax statement. Usually the issuer will send you a 1099 form. If you are interested you can get information on zero coupon bonds and tax consequences from the IRS Publication 17: http://www.irs.gov/publications/p17/. You could buy zero coupon bonds in your tax exempt account (i.e. IRA) and have no tax consequences.
The largest categories of zero coupon bonds are the following:
• Treasury securities
• Zero coupon corporate bonds
• Zero coupon municipal bonds
• Saving bonds
Treasury and municipal bonds also have interesting US tax consequences. Holders of municipal bonds may not have to pay local, state or federal taxes (this makes it cheaper for municipalities to fund projects since the interest rate will be lower than the market rate). Treasury bond holders may not have to pay local or state taxes either. Please review IRS publication 17 or talk with your tax accountant about the tax consequences of buying these bonds. If you are interested in calculating tax-free vs. taxable yield comparisons, you can use the following calculator: http://www.investinginbonds.com/calcs/taxcalculator/taxcalcform.aspx. Using the calculator and selecting my state, taxable income and filing status, I learned that if a municipal bond has a 3% tax free yield, the equivalent taxable yield would be 4.61%. This is a very simple tool for calculating yield for tax free bonds.
Zero coupon bonds may be a good alternative if you are working to a specific time frame such as a child's college tuition payments or your retirement, and if you intend to hold the bonds until maturity. For example, if the interest rate is 7%, maturity is 20 years and the face value is $20,000 you will pay around $5,050 for the bond and receive $20,000 when it matures in 20 years. The beauty is it’s very predictable; you pay $5,050 and receive $20,000 in 20 years.
Investors also buy treasury zero coupon bonds because they are very safe - they are backed by the full faith of the US government and treasury (the treasury can always print money to pay the bond holders). Zero coupon bonds have the same interest rate risk as all bonds and, if you need the cash flow, you can always sell the bond on the secondary market.
Next week, I will write about when I think inflation and interest rates may go up and why. I’ll also address what investments will be good investments with rising inflation and interest rates. Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.
Paul
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Hey did you by chance see anything about how inflation affect zero coupon bond VS other bonds. I think you can get zero under the TIPS program also
ReplyDeleteWe also need to find out what company makes and maintains the printing press at the fed. The ways things are going this company should be a buy :)
Zero couple bonds duration is the same as the maturity, coupon bonds duration is less than the maturity so zero coupon bonds would have higher interest rate risk.
ReplyDeleteI think there is going to be a lot of hiring at the print press company.