The longer the maturity, the greater the price sensitivity.
Therefore, if you want to bet on interest rates moving a particular direction, zero coupon bonds are your best way to maximize profit from any given rate move. For some investors, being more sensitive to rate changes is a negative rather than a positive. If you don't intend to hold your bond to maturity, you have to stay aware of market fluctuations, and extreme volatility for zero coupon bonds can work against you if rates don't move the way you want. Specifically, if rates rise, they make the value of your zero coupon bond go down, potentially forcing you to sell at a depressed price if your timing is bad.
Another problem with zero coupon bonds is that IRS laws typically force you to recognize taxable income every year. Despite the fact that you don't actually receive an interest payment in cash, the IRS requires you to impute the amount of interest you should have gotten, based on the initial yield. Fortunately, you might be able to avoid this issue by holding zero coupon bonds in a tax-favored account like an IRA. Despite their dangers, zero coupon bonds let you do some unusual things.
Rate speculation can be risky, but the rewards can be impressive if you make the right bet. Meanwhile, if you have specific cash needs at a given time that you don't want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals.
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Premium Services. Stock Advisor Flagship service. Rule Breakers High-growth stocks. If the certainty of zeros still appeal to you, Winter suggests this strategy: Put some money in zeros that mature in 20 years. Five years from now, buy more zeros that mature 20 years from that point, and so on.
If interest rates rise, you'll be able to invest at least some of your money at higher yields. Got a question?
Ask Kim at askkim kiplinger. Toggle navigation Menu Subscribers Log In. Search Close. The biggest disadvantage may be the overall tax implication.
Pros and Cons of Zero-Coupon Bonds
With zero coupon bonds, even though you do not receive any interest payment until maturity, the Internal Revenue Service treats assumed interest payments as income, so you pay taxes on annual income that is not realized. Of course, you do not have to worry about taxes if you are investing in a tax-deferred account, such as a retirement account or an individual retirement account. That is why zeros are very popular for any tax-deferred investments.
Keep in mind, however, that zeros issued by municipalities are generally exempt from federal taxes and possibly state and local taxes as well. Before buying, therefore, ask your broker or financial advisor if your bond is callable. If the bond is not callable, make sure the official paper states that the bond cannot be called by the issuer before maturity.
Although millions of dollars worth of zero coupon bonds are traded every day in the secondary markets, many zeros — especially some corporate zeros — may have limited liquidity.
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Also, it may be expensive to trade some zero coupon bonds in a secondary market. However, if you stay invested until maturity, you bypass the problem of liquidity with your investment. There are several types of zero coupon bonds. The most common ones are Treasury zeros backed by the U.
The illustration assumes an original-issue yield of 4. Since Treasury zeros are backed by the government, they are considered to be the lowest risk; and since they have a large secondary market, they are also the most liquid. Ratings go from AAA, the highest quality, to D, which means default.