Zero-coupon bond

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value.


 * Zero-coupon bonds or “zeros” result from the separation of coupons from the body of a security.
 * Zeroes sell at discounts from face value.
 * The difference between the purchase price of the zero and its face value when redeemed is the investor's return.
 * Zeroes can be purchased from private brokers and dealers, but not from the Federal Reserve or any government agency.
 * Zeros have the unique property of having a duration equal to their maturity. This has several consequences for investors:
 * A bond of a given maturity has much greater exposure to interest rate changes than a coupon-paying bond. For instance, a 30-year bond with a 5% coupon has a duration of just over 15 years; by contrast, a 30-year zero has a duration of 30 years.  Therefore, in a deflationary crisis where long-term Treasuries are expected to do well, zero-coupon Treasuries (STRIPS) will be the best performers.
 * The duration of a zero, unlike coupon-paying bonds or bond funds (excepting a few target-date bond funds), keeps pace with the reductions in investment horizon as time passes. This property makes zeroes precisely suited for investing to meet a known, fixed future obligation.  The lack of availability of inflation-indexed zeroes, however, limits the utility of this property to satisfying only known, fixed, future obligations valued in nominal dollars.  It is possible to create a portfolio of individual bonds or of bond funds that approximates this property of zeroes by  periodic rebalancing between bonds/funds of different durations, although such a scheme leaves the investor subject to yield curve shifts.  Creating a declining-duration portfolio of TIPS, however, would allow the reasonably certain satisfaction of a future obligation valued in real dollars.

Treasury STRIPS
While the U.S. Treasury initially opposed stripping of Treasuries into coupon-only bonds (known as annuities) and maturity-only bonds (zeros), several private firms were able to create unsanctioned versions on the private market. These issues were not interchangeable on the secondary bond market, making them fairly illiquid. The Treasury eventually created an authorized version known as STRIPS; the program continues to this day.

Zero-coupon Corporate Bonds
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Zero-coupon Municipal Bonds
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Tax Aspects
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Zero-coupon Bond Funds
American Century offers four Target dated zero-coupon bond funds, all set to mature and liquidate by a set maturity target date. Although it is convenient to purchase as a mutual fund, an investor should carefully compare the 0.57% expense ratio (which is paid every year) to the commission and bid/ask spread of purchasing a zero-coupon bond directly. In many cases (particularly long-dated bonds where you are planning to hold to maturity), purchasing the bond directly will likely cost less.


 * American Century Target 2010 (BTTNX), expense ratio (0.57%)
 * American Century Target 2015 (BTFTX), expense ratio (0.57%)
 * American Century Target 2020 (BTTTX), expense ratio (0.57%)
 * American Century Target 2025 (BTTRX), expense ratio (0.57%)

Vanguard offers an index fund, the Extended Duration Treasury Index Fund, based on the Barclays Capital U.S. Treasury STRIPS 20–30 Year Equal Par Bond Index. Unlike the American Century funds, this fund has no set maturity date, as the maturity is meant to remain at around 25 years. The fund is only available in institutional and ETF shares.

Links

 * Treasury Direct: STRIPS
 * Investing in Bonds: Zero-coupon Municipal Bonds

Papers

 * Minimizing funded ratio volatility with extended duration bonds