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Answer:
Dear
Tom,
You're
right. And zeros are important, especially for people
who know they must meet a major financial commitment
in the future, such as college tuition, buying a house
or financing retirement. That's because with zeros
you make a small initial investment and receive a
large balloon payment in the future.
How
Zeros Work
Zeros,
unlike regular bonds, pay no interest until maturity
-- in other words they have no "coupons" or periodic
interest payments. To compensate for this, zeros are
sold at a deep discount, well below the standard bond
price or face value of $1,000. And, they increase
in value at a compounded rate so that by maturity
they are worth much more than when you bought them.
To
state this another way, if you own zeros you will
receive just one lump sum payment - at maturity.
This payment is equal to the principal invested plus
the interest earned, compounded semiannually, at a
stated yield. (Non-zero coupon bonds normally pay
interest every six months.)
Zeros
come in denominations as low as $1,000 and the discount
from face value ranges from approximately 50% to around
75%, depending upon how long it is until maturity.
The
maturity dates on zero coupon bonds are usually long-term
- most, in fact do not mature for 10, 15 or 20 years.
As mentioned at the beginning, these long-term maturity
dates are very helpful when planning for a long-range
goal.
Types
of Zeros & Taxes
You
can purchase zero coupon bonds in the secondary market
that have been issued the U.S. Treasury, by state
and local governments and very rarely, by corporations.
Keep
in mind that because zeros pay no interest until maturity,
their prices fluctuate more than other types of bonds
in the secondary market.
And
even though zeros do not pay interest until they mature,
you must pay federal, state and local income tax on
the imputed or "phantom" interest as it accrues each
year.
$Tip:
You can avoid paying taxes by sticking with municipal
zero coupon bonds (if you live in the state where
the bonds are issued) or by purchasing one of the
very few corporate zero coupon bonds that come with
a tax-exempt status. Another way to avoid taxes is
to put zeros in your IRA where they will grow on a
tax-free basis while in the account.
Pros
& Cons
The
advantages are quite clear - you know precisely how
much you must invest now to get a certain dollar amount
on a certain date in the future. Secondly, you do
not need to be concerned with how to reinvest interest
payments which is the case with regular bonds.
On
the other hand, yields are lower than on ordinary
bonds, typically one-half to one percentage point
less. Treasury zeros, backed by the full faith and
credit of the U.S. government, are considered the
safest of all the zeros offered -- and therefore,
their yields are also the lowest.
If
you have more questions about zeros, please write
in again.
Good
luck!
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