Zero Coupons, Zero Worries?

If you think a prolonged stock market decline could force you to drastically scale back your rosy retirement plans, you might want to take a look at zero-coupon bonds. Like U.S. savings bonds, zeros don't pay out any regular interest. Rather, you buy them at a deep discount to their face value and collect the principal--guaranteed by Uncle Sam if they're Treasury zeros--at maturity. Moreover, unlike coupon-paying bonds, you don't have to worry about reinvesting periodic interest payments at lower rates should rates continue to drop. "They're absolutely fabulous," says Gerald Guild, chief taxable fixed-income strategist at Advest.

Most investors get into zeros via Treasury "strips", so named because the interest payments are stripped out by investment banks. Right now, they return about 5.5% annually for maturities 15 to 30 years from now. While that's near a historic low, many bond mavens expect rates to fall further. But because zeros lack coupon payments, which can be reinvested at current rates, trading prices can be extremely volatile. For example, a $1,000 strip maturing in 24 years yielding 5.5% now costs around $272. If rates fall another 100 basis points over the next 12 months, the bond would be worth $359. But if rates should rise 100 basis points, the bond would be worth only $230.

If you plan to hold a zero until maturity, you won't need to worry about price fluctuations. For retirement savers, Guild recommends constructing a "ladder" of bonds maturing at regular intervals (table). That would assure you a specific income each year, beginning when you turn 65, for example, and continuing for another 15 years.

TUITION PLAN. In addition to providing retirement income, zeros can fund other payments that come at a known date, such as a child's college tuition. But they have a major drawback when used in a taxable account. Investors are required to pay tax each year on phantom interest accrued by the bond, even though they never actually receive any cash until their bonds mature. That's why it's wise to buy zeros in an individual retirement account for use when you can withdraw the funds without penalty, typically after age 59 1/2.

There is one loophole you can use if you want to buy zeros for a taxable account. Some AAA-rated corporate zeros issued by Seariver Maritime and General Motors Acceptance Corp. enjoy tax-deferred status. Created in 1982 using an opening in the tax code that was soon closed, these securities have yields that are a bit higher than Treasuries, since they aren't backed by the U.S. government.

Even though this debt pays a bit more, don't buy zeros if you're worried about earning the absolutely highest yields. And since stocks have returned about 11% a year for the past 72 years, you should also allocate a portion of your retirement kitty to equities. But that decision ultimately depends on your risk tolerance. Indeed, zeros are best used to lock in cash for the future and free you from worries about interest rates or the stock market. They aren't very flexible, but they can offer you some security.

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