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Why Zero-Coupon Bonds Might Make Sense for You

When the economy loses speed, interest rates usually decline -- and in a falling-rate environment, zero-coupon bonds are typically among the best-performing fixed-income securities. To understand why requires a basic understanding of these investments and how they work.

Unlike traditional bonds, which pay interest twice a year, "zeros," as they are commonly called, pay no interest. They are issued at a discount from par (par is usually $1,000), and gradually rise in value as they get closer to maturity. Generally, the longer a zero's maturity, the deeper its discount and, therefore, the greater its overall return.

The return on a zero is the difference between the amount you pay for the bond and its value at maturity. For example, if you bought a zero for $500 and it matured in 10 years at $1,000, you would have a return of $500 on that security, for a compounded annual rate of about 7.18%.

A Popular Investment

Zeros have become popular with individual investors because they can help meet many needs. They are suitable for retirement and college planning. They are also appropriate for investors who want to lock in a guaranteed yield for a fixed time frame, add diversity to a portfolio that consists primarily of growth investments, or capitalize on an expected decline in interest rates.

Zeros tend to outperform other fixed-rate issues in a falling-rate environment because they are more interest-rate-sensitive than traditional bonds. (By the same token, when rates go up, zeros tend to go down in value more than most bonds.)

Since zeros pay no interest until maturity, you never have to worry about reinvesting interest payments, as you would with other bonds. (When rates are falling, interest payments from regular bonds may have to be invested at lower yields.) Moreover, you can sell zeros at any time. The amount you receive before maturity may be more or less than your original investment because of changing rates and market conditions.

You should be aware that interest on taxable zeros, although not paid until maturity, is taxed each year along the way.

Different Types of Zeros

Zero-coupon bonds are issued by the U.S. government, corporations and municipalities. Corporate zeros offer the highest yields. U.S. government zeros offer the most safety, because they are backed by the full faith and credit of Uncle Sam for the timely payment of interest and principal if held to maturity. No security issued by the U.S. Government has ever defaulted or delayed payment. Tax-exempt municipals have the lowest yields, but the income they generate is generally free from federal and state taxes for residents of the issuing state. Income from government securities is subject to federal income tax. Income from corporate securities is subject to federal and state income taxes.

Are zeros right for you? Which type of zero-coupon bond should you purchase? As with any investment, you should talk with your financial advisor. He or she can be a valuable resource in helping you select the most appropriate type of zero-coupon bond for your personal financial situation.

The market value of zero-coupon bonds fluctuates more with changes in market conditions than that of regular coupon bonds, so zeros may not be suitable for all investors. Please note that accrued interest is paid at maturity, but is subject to taxes annually as ordinary income, even though no income will be received by the investor. The absence of a coupon payment causes zero-coupon bonds to fluctuate in price more than interest-paying coupon bonds of similar maturity.

Income may be subject to state and local taxes or federal alternative minimum tax (AMT).

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