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Putting Compound Interest to Work

With Zero Coupon Bonds

In chemistry, a compound substance refers to a combination of two or more elements that cannot be separated. In math, a compound fraction means a fraction that has a numerator, a denominator, or both that contain fractions. In finance, compound interest means you’re likely to achieve your financial goals sooner.

The earlier you begin a regular investment program, the earlier compounding interest can go to work for you. As with most fixed-income securities, zero coupon bonds offer investors a high degree of safety when held to maturity and the opportunity to earn compound interest over the life of the bond. In addition, if you purchase a zero coupon bond issued by a state or local government entity, the interest compounds free of federal taxes, and in most cases, state and local taxes, too.

With conventional bonds, the investor pays the face amount of the bond and receives interest payments every six months based on the coupon, or interest rate, offered when the bond is sold. When the bond matures, the investor then is reimbursed the full principal amount invested.

When purchasing a conventional bond, you invest an amount equal to the face value of the security. As long as you own the bond, you receive regular interest payments and recoup the initial investment when the bond matures.

A zero coupon bond, on the other hand, is sold at a discount from its face value and the issuer makes no interest payments during the life of the security. When it matures, you receive the full face amount which equals your initial investment plus accumulated interest compounded over the life of the bond. (The examples cited refer to issues sold in primary market offerings.)

For example, an investor could purchase a 20-year municipal zero coupon bond with a face amount of $20,000 for approximately $6,757. When the bond matures, the investor receives the full, face amount, $20,000. The $13,243 difference is attributable to the accumulated compounded interest, in this case calculated on the basis of a 5.5% rate of return.

Because the bonds are sold at a discount to their face value, the investor also benefits from having a lower upfront amount to invest, an advantage for those who are just starting out or have more modest amounts to invest.

Zero coupon bonds were introduced to the fixed-income market in mid-1982. Today, the three largest categories of zero coupon securities are offered by the U.S. Treasury, corporations, and state and local government entities.

As with all bond issues, zero coupons issued by the Treasury are generally considered the safest because they are backed by the full faith and credit of the U.S. government. Municipal zeros also offer a high degree of safety, and, because the interest earned is usually tax-free, can generate higher returns when calculated on a taxable equivalent basis.

For example, an investor filing a joint return in the 27.5% tax bracket would have to purchase a zero coupon bond at 7.59% to equal the tax-exempt municipal yield of 5.5%. The savings add up further if the municipal zero coupon bond is issued by an entity in the investor’s own state.

Corporate zeros offer a potentially higher degree of risk, depending on the financial strength of the issuing corporation, but they also offer the opportunity to achieve a higher return. A zero coupon bond issued by a corporation or the U.S. Treasury is also taxable, unlike those offered by a municipal issuer. Even though you do not receive your interest payments in cash while you hold the bonds, you must pay income taxes each year on the interest as if you had. For that reason, you may want to purchase a taxable zero coupon bond for your Individual Retirement Account (IRA) or other tax-sheltered retirement account, such as a 401(k) plan.

Zero coupon bonds enable investors to tailor their purchases according to their own time horizons. For instance, there are zeros with maturities ranging from one to 40 years, with the majority between 8 and 20 years. So, if you’re investing for a specific objective, such as retirement, or the start of college tuition, zero coupon bonds provide you with the ability to time the maturities to when you need the money.

There are also different types and grades of bonds and, as with all bonds, credit quality is a factor. Most corporate and municipal zero coupon bonds are rated by the major rating agencies, Moody’s Investors Service, Standard & Poor’s, Fitch IBCA, and Duff & Phelps.

The benefits of compound interest, which zero coupon bonds provide, may be the way you can get started toward meeting your financial goals.