Investing-Zero Coupon Bonds

Zero Coupon Bonds - Why Are they so Special?

Created in 1982, zero coupon bonds intention was to offer a financial instrument to guarantee long-term investments in securities, backed up by big and stable organizations, like states or transnational companies.

TYPES OF ZERO COUPON BONDS

Also known as strip bonds, there are four types of them. The first one is known as zero coupon municipal bonds. Also known as government zero coupon bonds, they have the advantage of not being affected by federal taxes. And in some cases, they are not even affected by state or local taxes. As a consequence, the Return Over Investment (ROI) may be higher than other kind of zero coupon bonds. Another advantage is that they don't require a huge amount of capital. You only need a minimum of US$5000, an easily achievable figure in the USA. Additionally, it is rated as an A or even triple A investment, which has a high degree of liquidity. This is very practical if you need the money and wish to sell your securities. All of these reasons have created a market of US$124 billion for this type of bond.

Another kind is the zero coupon corporate bond. Although their ROI is higher than any other kind of bond, they are affected by federal taxes. But there are some other advantages. You may choose a wide portfolio of bond investments for you or your clients (many companies issue zero coupon bonds), they have a fair liquidity and are well ranked as instruments for investment.

The third type is known as zero coupon treasury bonds. This kind of bond is issued by the Treasury of the United States and is considered the safest type of bond since it is backed up by the United States government, a country that has existed for more than two hundred years.

Finally, the fourth type is called short term zero coupon bond. They reach their period of maturity in one year and are also known as bills. The US Treasury bill market is considered the most liquid debt market in the whole world.

But issuing zero coupon bonds ain't an easy task. Any organization, public or private, who wishes to follow this path, needs to comply with a series of requirements that guarantees the money of their investors. That's why there are entities that rate the risk of bonds. Remember that a higher risk means a higher ROI, but also the possibility to lose your money.

Why Zero Coupon Bonds Are Different from other Bonds

The main difference is that zero coupon bonds don't pay interests over the life of the bond, but at the end. That means that at the end of the period, let's say, twenty years, the investor will receive the initial amount of money that he invested, the interests over his investment and any additional money consequence of inflation. The second principal difference is the period of maturity of the bond. While traditional bonds can last only for some months, a common period for a zero coupon bond is of thirty years.In the case of normal bonds, the investor receives semiannual payments (depending on the conditions of the bond) during the life of the bond. But, as in the case of a zero coupon bond, he will receive the original amount of money only at the end of the term.

WHAT IS THEIR PURPOSE?

The principal interested for this kind of financial instrument is a pension fund. Since they need to leverage their portfolio of high risk investments, they immediately look at the bond market as a counterweight for any misshapen. From all the reasons indicated above, a zero coupon bond is one of the most recurred security by these entities.

Another kind of sector interested in these instruments are insurance companies, who manage huge amounts of money and have to search for different kind of financial services in which to invest.

Families and individuals are also keen to invest in zero coupon bonds. They usually use it as part of their retirement plan or as a long term investment for their kid's education.

WHERE DO I GET THEM?

If you are interested in buying zero coupon bonds, you may start at a mutual fund. They should have a variety of zero coupon bonds that are available in the market. You can also go to a broker and ask for the zero coupon bonds that they can offer.

At either of these options you should receive advice on which type of zero coupon bond you should acquire. They have the experience and knowledge to understand their clients and offer them the one that best suits their needs.

From all of these options, it seems that zero coupon municipal bonds are the most adequate for the small investor since it only requires a reasonable amount of money and offers a good ROI. But take note about this, you only can buy it if you live within the zone where it was emitted. In the case of pension funds and other kind of financial entities, the other type of zero coupon bonds seem as a more adequate choice for their kind of business.