Zero-coupon bonds, also known as “zeros” or “strips”,are an invention of Wall Street, and like many Wall Street innovations are inappropriate for the vast majority of investors. They are primarily instruments of speculation.
What are Zero-Coupon Bonds
The reason zero-coupon bonds are called “Strips” is because they are “stripped” of their coupon, or payment. An investment bank takes a plain vanilla US Treasury bond of any duration and separates the different revenue streams, coupon-only and principal-only, and repackages them as a distinct security. It doesn't really matter if you buy the coupon-only or principal only strip, since you don't get any interest coupons with either. You basically buy it at a deep discount from par, and redeem it at par. The difference is your interest.
Zero-Coupon Bonds Have No Reinvestment Risk
What's the point, you may ask? The point is that there is no reinvestment risk. The day you buy the security you lock in your return. With a bond, it kicks out interest every quarter which must be reinvested at the prevailing interest rates. If rates fell between issuance of the original bond and the time you reinvested the interest, you would have to reinvest it at a lower interest rate. Thus the buyer of a zero over a standard treasury would come out ahead, and vice versa if interest rates rose. One would buy a zero because there is no reinvestment hassle, and no reinvestment risk with a zero.
Wall Street Gets Their Piece
Remember that any time Wall Street innovates, that innovation is driven by one overriding reason….profits. Wall Street wouldn't sell zeros to you if it wasn't profitable to them to sell them. Mark-ups on zeros tend to be quite a bit higher than on a standard treasury and the market is not as liquid. You should be prepared to hold it to maturity if you buy it. According Annette Thau of The Bond Book, buying a standard treasury is often a better buy than a zero if the maturity is short, such as less than 5 years, because of the mark-up.
Beware the Phantom Taxes
Zeros, like most bonds, should be held in a tax-protected account. That's because you have to pay taxes each year on the gains, even though you don't actually receive them. This “phantom tax” (which also occurs with individual TIPS) is rather inconvenient to deal with. You can avoid it by only holding them in an IRA or other tax-protected account.
Beware the Volatility
The main reason I recommend you don't use Zeros is the same reason that speculators love them. They are highly sensitive to changes in interest rates. The reason is that their duration is equal to their maturity. Consider a standard treasury bond with a 30 year maturity. With a current yield of 3.7%, it's duration is about 19 years. A 30 year zero has a duration of 30 years. So if interest rates go up and new bonds are yielding 4.7%, the 30 year standard treasury loses 19% of its value, but the zero loses 30% of its value. Conversely, if rates go down, the zero goes up more.
Little Reason For An Investor To Own Zero-Coupon Bonds
Advocates for zeros tout their speculative characteristics, but in my opinion, a good investor doesn't spend his time and money speculating on something so unpredictable as future interest rates. Advocates also tout the ability to have a defined amount of money at a defined period of time. For example, if you knew you needed an exact amount of money in 20 years, you could buy a zero that would be guaranteed to be worth that amount today for a much lower price. Guarantees are nice, but if I were looking for a long term guarantee, I would want it to be adjusted for inflation, and zeros aren't.
As a general rule, bonds are for the safe portion of your portfolio, and you should take your risk on the equity side. Investors like Larry Swedroe, author of The Only Guide to A Winning Bond Strategy You'll Ever Need, advocate for keeping both credit risk and interest rate risk low in the bond portion of your portfolio. That argument makes a lot of sense. Buying zeros is doing the exact opposite of keeping interest rate risk low. Zeros aren't some magic way to make millions. They're just a demonstration of guaranteed nominal compound interest at work. If you like the volatility of long-term treasuries, perhaps zeros are for you. Given our current historically low interest rates, I'm not sure now is the time to be speculating that they're going to fall further.
What do you think? Do you buy zeros? Why or why not? Comment below!