The Pluses And Minuses Of Zero Coupon Funds

Zero-coupon bonds, popular investments since the early 1980s, have long been hailed for their predictable returns. Typically, you'd buy one from a broker, hold it to maturity, and that was that. But there's another way to invest in zeros and avoid big brokerage markups: no-load zero-coupon-bond funds.

Interest-paying bonds become zeros when the semiannual interest payments are "stripped" from their principal amount, or face value. That leads zeros to sell at a deep discount to their face value and pay back their principal when the bonds are redeemed at maturity.

The bond funds behave much like the zeros themselves. "Basically, the fund buys zeros maturing in the target year and then sits with them," says Thomas Poor, a bond-fund manager with Scudder, Stevens & Clark. "When you're quoted a yield on a zero and on a zero-bond fund, you can be reasonably assured that that's what you're going to get." Some funds might hold a slight cash position to cover expenses and pay dividends. That can lower the stated yield slightly.

The liquidity of a bond fund is one of its major attractions to investors who want to make a play on declining interest rates. A small drop in rates goes a long way in boosting the price of zeros before they mature. A one-point drop can cause a 32% increase in a fund investing in 30-year zeros, while a regular 30-year bond at 8% would rise about 11%. But the equation works against the fund if rates rise.

Scudder (800 225-2470), Benham Capital Management Group (800 472-3389), and United Services (800 873-8637) offer zero-coupon-bond funds with maturities ranging from 1995 to 2020. Minimum investments are $1,000 ($100 to $500 for IRAs), and expenses are about 1%.

The funds invest primarily in U. S. Treasury zeros called STRIPS (separate trading of registered interest and principal of securities). As of April 12, a $ 1,000 investment in Benham's 2015 fund would return $6,217 at maturity; in the 2020 fund, it would grow to $7,976. To play the rate game, you can switch out of a zero fund into another fund in a family, but some funds set limits. With Benham, it's six times. United Services' new, tiny (about $600,000 in assets) fund has no limit but charges a $5 switching fee.

One big problem: You're taxed on the "imputed interest" that accrues each year, but you may see no cash until you sell or the bonds mature. If you want to avoid that, put your fund shares in a tax-deferred retirement plan.

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