Great advantages for the better-off investor

By Neville Bennett

Friday 8th August 2003

There is a fixed interest play on the US market of a type not seen in New Zealand for many years. Zero coupon bonds have great advantages for the better-off investor. They provide an opportunity to spread currency risks and secure a uniquely cheap entry into the fixed-interest market.

When held to maturity, these bonds have a high degree of security plus compounding yields. They are free of federal taxes and usually other US taxes.

What is different about zero coupon bonds? In conventional bonds, the investor buys a bond for say $10,000 and receives regular interest rate payment for the life of the bond. When it matures, the initial premium is reimbursed.

However, a zero coupon bond is sold at a discounted premium from its face value. There are no regular interest payouts during the life of the security. At maturity the investor is reimbursed with his deposit plus accumulated interest.

In a concrete example, an investor could purchase a 20-year zero coupon bond issued by an American municipality. A bond with a face value of $20,000 can be bought for $6757. The difference between the purchase price and the final payment is accounted for by interest at 5.5% compound.

A lower-cost entry level into the bond market may suit some investors. It is obviously useful in providing for a retirement nest egg and could be a perfect present for a grandparent to a grandchild to help with education fees.

Zero bonds were first issued in 1982 and are now a large part of the market. There is a range of yields, with US treasuries offering absolute security but with varying credit-worthiness in offerings by corporations and municipalities.

There are zero coupon bonds with maturities of one year and others with 40. Most fall between eight and 20.

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