Why Buy?

Ground Zero

Are you a goal-oriented investor? Will you need $20,000 in five years to put a down payment on a house? $50,000 in 15 years for your child's education? $100,000 in 30 years for retirement? Zero-coupon bonds might be the perfect vehicle to help you reach those or other financial goals.

Issued by the U.S. Treasury, state and local governments, and corporations, zeros allow you to make a small investment today and know exactly how much money you'll receive on a given date in the future.

These bonds--unique in that interest payments are reinvested, compounding the interest--are particularly advantageous if you're just starting out and have little money to invest. Sold at steep discounts to their face value, the securities allow you to triple, quadruple, even quintuple your low upfront investment. For example, if you invest $174.11 today at 6 percent, you would receive $1,000 (face value) at the end of 30 years. No interest payments are made before maturity, hence the name "zero-coupon bonds." (The coupon rate is the amount of periodic interest paid to bond holders.)

"While zeros pay no current interest, you still must pay taxes on the year-to-year appreciation--which is phantom income," observes Phil Albitz, Certified Financial Planner at Albitz/Miloe & Associates in Torrance, California. "So you're paying tax on money you're not really receiving."

The solution? Buy a zero-coupon bond issued by a state or local government entity. The interest compounds free of federal taxes and, in most cases, free also of state and local taxes. If you prefer taxable Treasuries, Albitz suggests including such securities in qualified retirement plans. Zero coupons can be included in a 401(k) that covers you as well as your employees, or in an IRA or Keogh. "You can buy them at a big discount, wait until they mature, then get the total value of the bond but without paying the tax until you withdraw the funds," Albitz says.

The financial advisor, whose firm specializes in retirement planning, strongly urges entrepreneurs to establish a qualified investment plan and says, "Zero-coupon bonds should be one of the components of the investment portfolio." The securities typically are issued in $1,000 increments (face value at maturity), with maturities ranging from one to 30 years. The longer the maturity, the greater the yield.

Zero-coupon bonds typically are purchased from brokerage firms at minimal fees. "But watch for hidden markups," warns Albitz. "Find out first what the `bid' and `ask' [prices] are on the bond; the difference between the two represents the markup." As with buying a car, you may be able to negotiate a better deal with the broker if you know the markup. Or consider a no-load zero-coupon bond fund, which charges no fees.

Although full face value is guaranteed if zeros are held to maturity, they are not appropriate for all investors. Like other fixed-income instruments, they are subject to inflation risk. If interest rates rise, the price of these bonds will fall even more dramatically than other bonds--so you could lose big if you need to withdraw the money before maturity. (The inverse also is true: As interest rates fall, the value of zero- coupon bonds increases rapidly.) "But for someone who will hang on to [a zero] and is satisfied with the locked-in yield," Albitz concludes, "it's a good investment."

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This article was originally published in the September 1999 print edition of Entrepreneur with the headline: Why Buy?.

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