Zero-Coupon Bonds Provide Positive Yield

Deep discounts and security appeal to some investors

'Zeros" can quickly add up to thousands of dollars. At least when they are zero-coupon bonds, that is.

These bonds are one option for a person who wants a quiet savings and investing plan with guaranteed returns. Zero-coupons are the type of investment you can throw in the desk drawer for years and end up smiling.

Let's say you're 45 years old, and have net assets worth about $100,000. You want that money to be there for your retirement. But you'd still like to invest as much of it in the stock market as you can. How can you do that?

One way, says broker Michael Glascott of Prudential Securities Inc., is to buy long-term United States Treasury zero bonds.

Mr. Glascott's office in Chicago could sell you 100 25-year zeros, each with a face value of $1,000.

The cost to you: just a little over $15,600 for all 100 bonds - $153.86 each bond plus a broker's commission of $2.69 per bond. That's because zero-coupon bonds, like US Savings Bonds, are deep-discounted bonds. You pay an amount substantially less than the face amount. Over time, the bonds reach their stated maturity value.

So 25 years from now, when the bonds mature, you will get $100,000 back, an effective annual yield of 7.42 percent on your initial investment of $15,600.

The best part is, you now probably have a chunk of money - as much as $84,000 - free to invest in stocks.

"The bonds provide you a safety net for your other investing," Glascott says.

Zero-coupon bonds are so named because they do not have a "coupon" - that is, they do not pay current interest. The interest payment comes at the point of maturity. Thus, they are often used to guaranty funds for certain future events, such as balloon payments on a mortgage, or to pay off a mortgage, fund a college education, or to be used, as in the example above, as a safety net for a savings or investment plan.

Zeros come in diverse forms: US Treasury bonds, municipal bonds, and corporate bonds. Interest rates are highest for corporate bonds, which also have the most risk (because companies default more often than governments). Most corporate zeros are bought by large institutional investors.

The key point to remember in buying zeros, says Don Hollenbach, a spokesman for the US Treasury, is this: "The longer the term [until maturity], the greater the price volatility when interest rates change."

Speculators like zeros, because when interest rates fall, the value of the bond rises. They can then sell the bond to another investor for a profit. But if interest rates rise, the price of the bond goes down. Thus, if a person had to sell the bond before it reached its maturity date, he or she could lose value on the instrument. That's why experts recommend that zeros be purchased for specific purposes involving known time frames. If a child is going off to college in 10 years, for example, you would want a zero that matured in exactly 10 years - not 15.

Short-term zeros pay lower rates of interest, but they are not as subject to price fluctuation. Thus, Glascott of Prudential offers a five-year $1,000 Treasury zero bond with a net yield of 6.6 percent (compared with 7.42 percent for the 25-year bonds) that will mature on May 30, 2001; it costs $720, including commission charges.

In buying zeros, you should seek to lock in rates at the highest point of the interest rate cycle, says Ray Worseck, chief economist at A.G. Edwards a St. Louis investment house. This past week, the yield on the 30-year Treasury bond was about 7.06 percent. Mr. Worseck predicts that yields on the long-bond "might move to around 7.50 percent by Labor Day, before falling back." Thus, he says, you might want to wait a little longer for slightly higher yields.

One drawback to zeros: You have to pay annual income taxes on the interest accumulated each year, even though you don't actually receive the interest until the bond's maturity date. To avoid paying for this "phantom interest," some people buy the bonds for their tax-sheltered retirement accounts, such as an IRA. Or they buy tax-free municipal zeros, or put the bonds in the name of a child who pays no income taxes.

The most popular zeros are called US Treasury "STRIPs." They can be purchased from brokers or dealers, not from the Treasury directly, but are backed by the full faith of the US government.

Zeros can also be acquired through mutual funds. But management fees can sharply reduce returns. Thus, before buying a zero fund, you should check fees and compare yields.

For individual bonds, yields and costs can vary among brokers. For non-Treasury zeros, experts say, make certain the issuer is creditworthy and that the bond is not callable - that is, the issuer can't redeem the bond before maturity, leaving the bondholder with less than the expected return.

Finally, you should remember that zeros are unlikely to outperform stocks as a long-term investment.