STRATEGIC CONSIDERATIONS

As we have seen, zero coupons share many of the characteristics of bonds, with one important exception for the investor. Since they do not feature regular interest payments, they are not an income investment, as bonds are, but should be considered an appreciation investment.

It is important to remember, however, that unlike the growth in value of a stock portfolio or mutual fund, the appreciating value of a zero is really a representation of accrued compound interest, and is taxed as such—not capital gains, which are taxed at lower rates. There are, however, a variety of tax-free government zeros available.

Since zeros are debt instruments, the risk involved depends largely on the credit strength of the issuer. Zeros backed by government securities like U.S. Treasury bonds have very low credit risk, while corporate zeros can be much riskier. If the issuer does default, you may be out quite a bit, because you have not received any interest payments. Also, as with bonds, the real values of zeros depend on how the returns compare with prevailing interest rates—a factor that makes zeros quite volatile on the secondary market. As a result, most investors hold zeros to maturity.

Now let's summarize what we have learned about zero coupon securities.