The Limits on Zero-Coupon Bonds

Kiplinger's Personal Finance Magazine, Feb, 1999 by M.S.

Zero-coupon Treasury bonds have been on a tear, and returns of American Century-Benham Target funds bear this out. The Target 2025 fund, which owns zeros maturing that year, gained 23% in 1998 to December 15. The longer-term numbers are also superb.

These gains are not surprising. Zeros are bonds that are sold at a deep discount to face value. They don't make interest payments. Instead, investors receive their ultimate reward when the bond pays off at face value at maturity. In the interim, zeros fluctuate with stocklike volatility: Prices soar when interest rates fall and plunge when yields rise.

But with Treasuries yielding about 5%, one wonders how much further yields can fall. Some experts think inflation is low enough that long-term Treasuries yielding 4% or lower are possible. A sharp drop like that over the next year would probably result in another stellar gain for Target 2025 fund.

But consider this: The Target 2015 fund has returned an annualized 15.3% over the past ten years (meaning investors have quadrupled their money). For the Target 2025 fund to achieve a similar return over the next ten years, long-term yields would have to fall below 1%, estimates the fund's manager, David Schroeder:

Zeros are one way to guarantee that a certain amount of money will be available at a specific point in the future. You can, for example, invest roughly $625 in a zero-coupon Treasury maturing in February 2009 and know you'll get $1,000 in ten years. The 4.7% yield to maturity may look skimpy, says Bubba Bennett of Prudential Securities, but isn't too shabby with inflation at less than 2%.

One problem with Treasury zeros is that you must pay taxes on the "phantom," or imputed, income they generate each year. Bennett recommends zero-coupon municipal bonds as an alternative. Fifteen-year insured muni zeros, he says, recently yielded a tax-free 4.85% to maturity.