There's a common perception among investors that bonds are boring. Stock prices go up and down like a long roller-coaster ride, while bonds are more conservative, less volatile investments that let fearful savers sleep better at night. Many financial advisors suggest that their clients add bonds to their portfolios to help smooth out fluctuations in their overall net worth. Although corporate bonds can move sharply from time to time, as bondholders in bankrupt Delta Air Lines found out after news of a potential takeover by US Airways (NYSE:LCC), bonds have historically done a good job of dampening portfolio volatility.
However, if you believe that interest rates are primed to move in one direction or another, then there's a way to make the most from your prediction if you're right. By using zero-coupon bonds, you can get the most bang for your buck and maximize your return if rates move your way.
Why zeros are different
What makes zero-coupon bonds stand out from traditional bonds is the way they make payments back to their owners. With a traditional bond, you usually pay a price that is relatively close to the face value of the bond. You can generally expect to get interest payments at regular intervals over the course of your owning the bond, and when the bond matures, you get the face value back from the borrower. How much interest you get is defined by the interest rate on the bond, which is also known as the coupon rate.
Zero-coupon bonds, on the other hand, have much different price characteristics. When you buy a zero-coupon bond, you usually pay a price that is significantly less than the face value of the bond. For instance, if you want to buy a zero-coupon Treasury bond that matures 15 years from now, you'd have to pay only about half of the face value. The tradeoff, however, is that you don't get any interest payments. The only payment the borrower makes is the final payment of the face value at maturity. The difference between what you pay and the face value represents the interest on the bond.
Big potential price moves
Zero-coupon bonds are especially sensitive to changes in interest rates. As a general rule, the price of a bond is determined by figuring out the present value of each interest and principal payment and then adding all the present values together. When interest rates change, then the present value of each payment will change as well. Furthermore, the present value of payments to be made far in the future will rise or fall to a greater extent than the present value of payments in the near future.
Traditional bonds make a large number of payments. For instance, a 30-year Treasury bond makes 60 different payments of interest or principal over its lifetime; investors receive interest every six months and are repaid their principal at the end of the 30-year period. When interest rates change, the present value of the interest payment due six months from now doesn't change very much, while the present value of the principal payment due 30 years from now changes significantly.
Zero-coupon bonds, on the other hand, make only one payment at maturity. Therefore, when interest rates change, the whole value of the bond changes more sharply because its payment is far in the future. With bond rates at 5%, a given change in interest rates will move the price of a 30-year zero-coupon bond roughly twice as much as a traditional 30-year bond's price. For example, using The Motley Fool's trusty bond price calculator, you can see that if rates fall to 3%, the value of a traditional 30-year bond would rise about 39%, while the value of a 30-year zero-coupon bond would rise more than 82%. Note, however, that this applies to adverse rate movements as well. If rates rise to 7%, then the value of the zero-coupon bond would fall nearly 45%, while the value of the traditional bond would fall a less dramatic 25%.
As you can see, investing in zero-coupon bonds gives you much greater exposure to price changes resulting from interest-rate movements. If you're convinced that rates will fall, then buying zero-coupon bonds will make you the most money.
Phantom taxation and zero-coupon bonds
There is, however, a quirk in the tax laws that you should be aware of before investing in zero-coupon bonds. In most cases, individuals don't have to pay tax on income until they actually receive it. At first glance, this would make zero-coupon bonds extremely attractive; because you wouldn't receive interest until maturity, you might think you wouldn't have to pay tax until maturity. The delayed payment would essentially give you a chance to defer tax for as long as you chose.
But Congress didn't want to allow that loophole, so the tax laws don't allow zero-coupon bondholders to wait until the bond matures before including interest as taxable income. Instead, bondholders must treat a certain amount as interest each year, even though the bondholder doesn't actually receive any interest in cash. This accrual requirement applies because the zero-coupon bond qualifies as what the IRS calls an original issue discount instrument, by virtue of its current price being significantly less than its face value.
Some people refer to this stipulation as "phantom taxation," since you have to pay tax on money you haven't actually received. If you hold zero-coupon bonds in taxable accounts, you'll have to find money from other sources to pay the tax. On the other hand, you can avoid the issue if you buy the bonds in an IRA or other tax-deferred account.
With their high sensitivity to interest rates, zero-coupon bonds can add some spice to a sedate bond portfolio. As a tool for profiting from interest rate-movements, zero-coupon bonds may allow you to magnify your returns.
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For more on bonds and other fixed-income securities, take a look at the Fool's Bond Center, where you'll find the basics of what bonds are and how you can add them to your portfolio. You can also check out fellow Fool contributor S.J. Caplan's ongoing series of articles on the bond adventures of Investor 007.
Fool contributor Dan Caplinger isn't much of a coupon clipper. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy gives you much more than zero.
