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Ground Zero Zero-coupon bonds

By Paul DeCeglie

Opinions expressed by Entrepreneur contributors are their own.

Business Start-Ups magazine, September 1999

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

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

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

"While zeros pay no current interest, you still must paytaxes on the year-to-year appreciation--which is phantomincome," observes Phil Albitz, Certified Financial Planner atAlbitz/Miloe & Associates in Torrance, California. "Soyou're paying tax on money you're not reallyreceiving."

The solution? Buy a zero-coupon bond issued by a state or localgovernment entity. The interest compounds free of federal taxesand, in most cases, free also of state and local taxes. If youprefer taxable Treasuries, Albitz suggests including suchsecurities in qualified retirement plans. Zero coupons can beincluded in a 401(k) that covers you as well as your employees, orin an IRA or Keogh. "You can buy them at a big discount, waituntil they mature, then get the total value of the bond but withoutpaying the tax until you withdraw the funds," Albitz says.

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

Zero-coupon bonds typically are purchased from brokerage firmsat minimal fees. "But watch for hidden markups," warnsAlbitz. "Find out first what the `bid' and `ask'[prices] are on the bond; the difference between the two representsthe markup." As with buying a car, you may be able tonegotiate a better deal with the broker if you know the markup. Orconsider a no-load zero-coupon bond fund, which charges nofees.

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

Contact Source

Albitz/Miloe & Associates, (310) 373-8861

Paul DeCeglie (MrWritePDC@aol.com) is a formerstaff reporter for Journal of Commerce and AmericanBanker.

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