A Closer Look at Zero-Coupon Bonds

zero coupon bondsIt has been a long time since I searched the inventory of available zero-coupon bonds. But given the dearth of investment articles on zero-coupon bond opportunities, I thought I’d write a bit about what I discovered when recently searching for currently-available zeros trading on the secondary market.

To see a list of high yielding CDs go here.

Before sharing some of the results, let me first remind readers that zero-coupon bonds are bonds that do not have coupons. Instead, the bonds are issued at discounts to their face value, and interest is paid in one lump sum at maturity. But just because an investor receives no income from a zero-coupon bond until maturity does not mean the IRS will let that investor off scot-free. Imputed interest is interest investors are considered to have received, even though no interest was actually received. And the IRS requires investors to pay taxes on imputed interest.

I have a bit more to say about zero-coupon bonds in one of my books, The 5 Fundamentals of Building a Retirement Portfolio. For the remainder of this article, however, I would like to share a general overview of what’s out there in zero-coupon-bond land.

Municipal Zero-Coupon Bonds

  • Many are available for purchase.
  • The highest-yielding inventory is dominated by Puerto Rico, and California and Illinois municipalities.
  • In the investment-grade space alone, there are well over 100 zero-coupon munis currently yielding more than 5%.
  • Extremely illiquid – No bids are offered across the board. If you try to sell a retail-sized order, you will very likely not receive a price you find respectable at the then-current rates.

Corporate Zero-Coupon Bonds

  • Far fewer opportunities exist than in the municipal bond space.
  • When running a screen for “corporate” zero-coupons, the bonds returned by the screen were mostly of non-governmental organizations and one nation’s sovereign bonds (sovereigns often lumped into corporate bond screens).
  • The list is dominated by triple-A-rated International Bank for Reconstruction and Development (IBRD) bonds as well as triple-A-rated Kreditanstalt für Wiederaufbau (KfW) bonds and Israeli sovereign debt.
  • KfW debt is backed by the German government, and the Israeli zero-coupon bonds I came across are backed by the U.S. government.
  • One actual corporate bond of interest is Merrill Lynch’s 9/25/2018 maturing zero-coupons, which are asking 89.588 cents-on-the-dollar for a 2.255% yield-to-worst (CUSIP 59018SQ23).
  • The highest yielding triple-A-rated zero-coupon bond returned by the screen was CUSIP 45905UBH6, a 5/1/2030 maturing bond asking 50.045 cents-on-the-dollar—a 4.239% yield-to-worst.

U.S. Treasury Zero-Coupon Bonds

  • There are two types of U.S. Treasury zero-coupon bonds available: Bills and STRIPS.
  • Bills mature in one year or less.
  • Bills are considered cash-like instruments and play an important role in the functioning of today’s global financial system.
  • STRIPS, which stands for Separate Trading of Registered Interest and Principal of Securities, allow investors to own individual interest and principal components of various Treasury notes and bonds.
  • Even though stripped interest securities and stripped principal securities are currently trading with relatively similar yields, I could imagine a situation in which a U.S. government default in the form of delayed interest payments (while Congress tries to reach a future debt ceiling deal) causes interest-based STRIPS and principal-based STRIPS to diverge.
  • STRIPS often offer investors slightly higher yields than do non-zero-coupon bond Treasury securities of similar maturities. That is true today.
  • STRIPS usually have slightly wider bid-ask spreads than do non-zero-coupon bond Treasuries.

Agency Zero-Coupon Bonds

  • The Agency zero-coupon bond space has a similar number of bonds available for trading as the corporate bond space does.
  • Fannie Mae and Freddie Mac made up all the issues returned by my screen.
  • Credit ratings ranged from single-A to triple-A.
  • Yields ranged from 4.208% (CUSIP 3136F1EQ9) down to 0.215% (CUSIP 3134A1JD3).

Even though I think benchmark interest rates will stay lower than most people think for longer than most people think, I am open to the possibility of being wrong. I can express that openness by not locking in large amounts of future interest payments at today’s rates (zero-coupon bonds provide compounded returns). While I wouldn’t object to owning a select few zero-coupon bonds in my portfolio, I don’t think it is worth the risk of building a diversified allocation to zeros at this time. Instead, I would favor investing in non-zero-coupon bonds and making decisions about how to allocate the interest payments as I receive them.

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