When I was in my early 30s, I came in contact with Zero Coupon Bonds. This type of bond known as Zeros pay interest only when they mature. The advantage of this type of bond is that investors pay a relatively small sum for the bond when purchased. At maturity, investors receive a large payback. Zeros come in face values as low as $1,000. They are sold at large discounts of 50% to 80% of its face value, depending on how long you wait to collect the interest at maturity.
Let me give you an example. An investor could buy a $1,000 Zero Bond, yielding 7.5% that matures in 20 years. That bond would probably be purchased at $235. At maturity, the investor will receive $1,000.
Buy the bond with little money when she is born. At maturity 18 years later, use it to pay for her college education when she enters college.
The longer the term of the Zero, the less you the investor will have to pay now to buy a Zero. Another advantage of the Zero is that it is easy to figure out how much the investor will have at maturity.
The longer the term of the Zero, the less you the investor will have to pay now to buy a Zero. Another advantage of the Zero is that it is easy to figure out how much the investor will have at maturity.
If you do not receive interest on your bond every year, you cannot compound your interest in your account. The reason why I have a year to date 20.45% return as of Nov. 6, 2012 is because of compounding.
If the company files for bankruptcy, you may never see that interest.
Now let’s talk about the disadvantages. Taxes are a potential drawback if you purchase these bonds outside of your retirement account such as an IRA, 401K, Keogh, Defined-Contribution Plan, or other retirement programs. Investors don’t actually receive interest on the Zero each year but the IRS still tax the interest as if you received it. The problem, you are taking business risk meaning that you may never receive that interest. What if the company goes out of business or defaults on its debt? The investor may never receive that interest but the investor paid taxes on it.
If the company files for bankruptcy, you may never see that interest.
Now let’s talk about the disadvantages. Taxes are a potential drawback if you purchase these bonds outside of your retirement account such as an IRA, 401K, Keogh, Defined-Contribution Plan, or other retirement programs. Investors don’t actually receive interest on the Zero each year but the IRS still tax the interest as if you received it. The problem, you are taking business risk meaning that you may never receive that interest. What if the company goes out of business or defaults on its debt? The investor may never receive that interest but the investor paid taxes on it.
Zeros are much more sensitive to interest rate changes than regular bonds. This can be a curse if the investor does not hold the bond to maturity. The investor may sell the bond at a loss. But if rates fall, the investor may sell the bond at a substantial profit.
In my opinion, outside my retirement account, I would speculate using Zeros on the direction of interest rates. If I was just starting out in a retirement program, I would start by buying Zeros because they are cheap and safer than stock.
If I have new born children, I would buy Zeros for their advance education after high school.
Investors can calculate how much they will expect to have when the Zero matures.
No comments:
Post a Comment