Zero Cupon Bonds

Zero coupon bonds are an interesting derivative investment. As we shall see, they are not necessarily a great investment for long-term investors. 

Where do zero's come from?

We think of bonds as having two parts, an income stream usually payable each six months, and a principal value payable on maturity. If we could divide them into two parts, then some investors might prefer an income stream with no principal repayment, and other investors might prefer only the principal repayment. So, a large institution buys a few hundred million dollars of 30-year treasury bonds, holds them as custodian and sells rights to the two parts to different investors. 

High risk

Treasury Zero's (sometimes called strips) are very high risk. Even though they are backed by a US Government bond, they fluctuate much more than a regular bond because they don't have the coupon payment to stabilize them. 

As it turns out, the principal value is a small part of the total value of a bond. Interest payments are a far more valuable component. The market value of the zero is the face amount discounted back to a present value using the current interest rates. For instance, if we had a new $10,000 thirty-year treasury bond at 7%, the value of the principal would be only $1313.67. The balance of $8686.33 is the value of the interest payments. 

Very small interest rate changes will whipsaw the principal value of the bond. The longer the time to maturity, the more extreme the fluctuations become. For instance, if interest rates rise 1% on our 30-year 7% zero then the market value drops about 24% to $993.77. These extreme changes in value make the zero an attractive tool for speculators, but not very attractive to long term investors. An economist would call zero coupon bonds an inefficient investment because they have a high level of risk compared to their expected return.

Phantom Income

If you hold zero coupon bonds in a taxable account you will have one more interesting problem. You must pay income tax, at ordinary rates, on the theoretical increase in value each year. But, the bond doesn't throw off any cash flow. You will have to dip into your other funds to pay the tax. Even worse, you will get to pay the tax even if the value of the bond has gone down. This strange tax treatment is sometimes referred to as phantom income. The IRS adopted it to prevent taxpayers from realizing capital gains on the appreciation of an asset that should normally produce ordinary income. Of course, the tax reduces the nominal yield. 

Summary

Primarily as a result of the principal risk, we don't recommend them as a substitute for cash or short-term bonds. After all, this is the part of the portfolio that we count on to be available for emergencies and to produce income regardless of the current state of the market or level of interest rates.

We prefer to take very low risk in our bonds so that we can take more equity risk where it will be better compensated over the long haul. The resulting total portfolio should produce the maximum return for each unit of risk that the investor accepts.