Fashionable zero coupon bonds call for some careful shopping

The newspaper ads are filling up with zeros. They're not talking about the number of zeros in the federal deficit, but about a ``hot'' investment idea that is catching on with the public, corporations, and state and local governments. This zero is the zero coupon bond, and it's becoming one of the fastest selling of the newer investments, particularly for retirement and college savings programs. In fact, that's about all zeros are good for, a fact often overlooked by investors rushing to try on this latest fashion.

A zero is a bond purchased at a deep discount from the face value and paid off at this value at maturity. There are no -- or zero -- coupons for interest payments to clip during the life of the bond. Instead, the interest adds up and compunds automatically. One of the best-known zeros is the United States Savings Bond, which is purchased at a 50 percent discount and matures in eight to 10 years.

But the zeros showing up in those newspaper ads have far more dramatic returns. For instance, $2,000 in a zero coupon bond earning 11 percent would yield nearly $50,000 in 30 years. The same amount put in a money market mutual fund would earn about half that, assuming current interest rates held. Interest rates could, of course, go up. But they could also go down. With a zero you know exactly how much you'll have coming and when.

Knowing the future payout is important to corporations and municipalities, as well as with the US government -- which is why they're as interested in issuing zeros and investors are in buying them.

One problem with corporate zeros is security. Even though bondholders, including those holding zeros, have a higher claim to a company's assets than stockholders, a default is possible. So you should examine a company's bond rating for a zero as carefully as you would any corporate bond purchase.

``There are risks in corporate zeros,'' says Stephen Monheim, senior vice-president and director of financial services at Butcher & Singer, a Philadelphia-based brokerage. ``But there are also some good values. Just look into the company's overall bond rating.''

Since people thinking about retirement and college education funds also tend to think about safety, they have not rushed to buy corporate zeros. Instead, the zero of choice has been based on US Treasury bonds. These bonds are bought by securities firms at discounts of 20 to 90 percent off their face value, divided into semiannual coupons and principal, and resold in pieces as TIGRS (Treasury Investment Growth Receipts), CATS (Certificates of Accrual on Treasury Securities), or one of a few other, less-c ommon names.

TIGRS or CATS sold for a couple thousand dollars, including brokerage fees, would yield close to $20,000 in 20 years, assuming an 11.75 percent yield.

Another group of active players in the zero game are cities and towns. Their zero-coupon municipal bonds have the advantage of income that is free of federal taxes, and local taxes, if the investor is a resident of that city or state. But these should be approached with the same caution used for corporate zeros. A municipal default was once considered unthinkable; but not anymore.

In order of safety, Mr. Monheim rates US government zeros -- and CATS and TIGRS based on them -- on top. After that he lists municipalities and corporations.

You can also buy zeros now from savings-and-loans, though these are not really bonds. Instead, they are certificates of deposit purchased at a large discount and paid off at maturity. Safety here should not be a problem if the S&L carries federal deposit insurance. Interest rates, however, may be an issue, since rates on S&L zeros are apt to be slightly lower than on CATS, TIGRS, corporate, or municipal zeros.

Except for municipal zeros, the biggest drawback to all of these investments is taxes. Even though you don't receive any interest income until they mature, the Internal Revenue Service does not quite see it that way. As far as the IRS is concerned, you have received the income, even though you haven't seen it. That's why it's called ``phantom income.''

That is also why most zeros are purchased for individual retirement accounts, Keoghs, pensions, and custodial accounts, where taxes are deferred at least until final withdrawal. In a college savings account, taxes may still have to be paid, but at the child's lower rate.

``They're good for people setting aside money for their kids or grandkids,'' says Bruce Dayton, a financial planner in Weston, Mass. ``I had a client come in recently who wanted to buy one for a two-year-old grandchild.''

Mr. Dayton does not use zeros much for his clients' active accounts, however, since he tends to move money around in them somewhat frequently, to meet clients' changing needs and goals.

This gets at what is perhaps the biggest problem with zero coupon bonds: what to do if you need the money before they mature. If you are using zeros for an IRA, for instance, you should probably not put all your IRA money in them. Despite early-withdrawal penalties and having to pay taxes on money received early, there are emergencies when people need the money.

In situations like this, you have to try selling your zeros on the secondary market, made up of investors looking for bargains. They may not be willing to give you full value for your bonds, perhaps far less than what you think they're worth.

More important, while the stated interest rate applies if the bonds are held for the full term, in the interim, the rate can swing widely. If the rate you're getting on the secondary market is somewhat less than you paid, you could lose whatever gains were made up to then.

If you have a question that would make a good subject for this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given. References to investments are not an endorsement or recommendation by this newspaper.

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