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INTRODUCTION TO ZERO COUPON BONDS
To understand how zero coupon municipal bonds work, it is important first to become acquainted with the principal characteristics of both municipal bonds and the zero coupon bond structure.

Zero coupon bonds were introduced to the fixed-income market in 1982. They were — and still are — a unique concept in the marketplace. While most municipal bonds provide semiannual interest payments, zero coupon bonds, as their name suggests, have no coupon or periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. Zero coupon bonds are sold at a substantial discount from the face amount. When a zero coupon bond matures, the investor receives the full face amount of the bond. For example, a bond with a face amount of $20,000, maturing in 20 years, may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,757 represents the interest. This example is based on an interest rate of 5.5% which compounds automatically until the bond matures.

Zero coupon bonds are more volatile than bonds that pay interest regularly.

CHARACTERISTICS OF ZERO COUPON MUNICIPAL BONDS
Zero coupon municipal bonds combine the benefits of the zero coupon instrument with those of tax-exempt municipal securities and offer the following advantages:

Tax Advantages
Because zero coupon municipal bonds offer the benefit of compound interest free from federal income taxes, they provide returns that are often much higher on a net basis than comparable taxable securities. Further, tax-exempt zero coupon municipal bonds earn interest that, in many cases, is also free from state and local taxes. (Certain out-of-state municipal bonds may be taxable at the state level. Check with your tax attorney or advisor). In contrast, taxable zero coupon bonds are taxed each year on the amount of interest that has accrued for that year even though the accrued interest is not actually paid to investors in that year.

If an investor buys a zero coupon bond at other than the original offering or if the investor sells the bond before it matures, then, like any other fixed-income investment, there is a possibility of capital gain or loss.

Low Minimum Investment
Zero coupon municipal bonds are typically sold in denominations of $5,000 face amounts. But because they are sold at a substantial discount from face amount, you can purchase more zero coupon bonds for your money than other types of bonds. The greater the number of years a zero coupon bond has until maturity, the less you have to pay for it. Zeros allow investors to put aside a modest amount of money today and know exactly how much money they will receive on a specified future date.

Protection from Reinvestment Risk
Zero coupon municipal bonds provide investors with the opportunity to lock in a particular rate of return, without having to worry about reinvestment risk or interest rates in the future. Investors in securities that pay interest semiannually may not always achieve a total realized compounded yield which is equal to the quoted yield to maturity they expected when they purchased their holdings. Depending on future prevailing interest rates, their interest payments may be reinvested in lower- or higher-yielding vehicles.

A Wide Choice of Bonds
An investor in zero coupon municipal bonds has a wide choice of investment vehicles. There are zero coupon municipal bonds available with maturities ranging from one to 40 years, with the majority of these bonds having maturities between eight and 20 years. There are also different types and grades of bonds from which to choose. The type you select will depend upon your reward objectives, risk tolerance and investment conditions.

Quality

The majority of zero coupon municipal bonds are rated A or better by the three major rating services:
	Moody’s Investors Service
	Standard & Poor’s
	Fitch Ratings (see “Assessing Risk” below)
Many zero coupon municipal bonds carry insurance and are rated triple-A. In short, safety-conscious investors will be able to enjoy a high degree of credit quality, depending on the particular issues they select.

Liquidity
Should you have to sell your zero coupon bonds before they mature, you may do so in a generally active secondary market at prevailing market prices (see “Market Risk” below).

VARIATIONS OF ZERO COUPON MUNICIPAL BONDS
There have been several innovations in the municipal zero coupon bond market in recent years including Convertible and Stripped bonds.

Convertible Zero Coupon Municipal Bonds
These bonds start as zero coupon bonds and then, generally after eight to 15 years, convert to interest-paying bonds. They are ideally suited for individuals planning for retirement. During working years, individuals can accumulate capital — tax free — so it is ready for them when they retire. Then, upon retirement, they can receive the income stream they need for living expenses.

Stripped Municipals
Municipal bonds which pay interest semiannually can be separated (i.e., stripped) into the corpus and the coupons. The cash flow of the coupons is repackaged into stripped municipals with a greater variety of maturities — from six months to 30 years. Like zeros, stripped municipals are issued at a deep discount from face value and are available in a wide range of credit quality.

HOW TO USE ZERO COUPON MUNICIPAL BONDS IN YOUR FINANCIAL PLANNING

Zero coupon municipal bonds are attractive to investors seeking tax advantages and long-term capital accumulation for retirement, education funding or other long-range savings goals. Individuals can time the maturity of their investment to match their future needs. Here are some of the reasons to invest in a zero coupon municipal bond:
	Retirement planning — Zero coupon municipal bonds can be used to supplement a retirement savings program. They are not, however, suitable for Individual Retirement Accounts (IRAs) or qualified pension plans because these plans already have tax- advantaged status.
	Education funding — A municipal zero portfolio can be structured to mature during a child’s or grandchild’s college years.
	Gifting — Assets given today under the annual estate and gift-tax exclusion of $11,000 per person can continue to grow with the tax benefits of zero coupon municipal bonds.
	“Kiddie tax” — Zero coupon municipal bonds are more attractive than ever before for gifting to minor children under age 14. Since passage of the Tax Reform Act of 1986, Uniform Gift to Minors Accounts generating more than $1,600 in annual income for these children are taxed at the parents’ or guardians’ rates.
	Supporting on elderly parent — In today’s aging society, more people are spending large amounts of money providing care for their aged parents. Zero coupon municipal bonds purchased now can help meet those future needs.

ASSESSING RISK

Credit Risk

Assessing credit risk is particularly important for zero coupon bonds since all your return occur at maturity. For municipal securities, credit risk is determined by the financial and operating stability of the state or local government entity issuing the security.

You should assess the creditworthiness of a zero coupon municipal bond the same way you would any municipal security. Virtually all new issues of municipal securities are originally offered by means of official statements or offering circulars that describe in detail the financial condition of the issuer or, in the case of bonds such as lease-rental revenue bonds, the financial condition of the user or lessee.

From these documents, investors can determine the risks involved in the investment. In assessing the relative quality of zero coupon municipal bonds, many investors place a great deal of reliance on the ratings provided by one or more of the three major rating agencies.

The rating agencies grade bonds according to their investment qualities but do not intend the rating to be the sole basis for an investment decision. The ratings cannot, for example, forecast market trends.

Generally, bonds that are rated at least BBB or Baa by Standard & Poor’s and Fitch Ratings or Moody’s, respectively, are considered to be “Investment Grade,” or suitable for preservation of invested capital. Bonds with lower ratings, however, may also suit certain investment purposes.

Market Risk

As with all fixed-income securities, the yields or interest rates on zero coupon municipal bonds move up and down, usually in step with general market rates. Although the interest on your particular bond is fixed by the price you paid, newer issues may be offered at higher or lower rates of return depending on prevailing interest rates.

Zero coupon municipal bonds purchased when interest rates were higher may be sold in the secondary market when interest rates are lower to generate capital gains. However, interest rates move up as well as down, and during periods of rising interest rates, investors selling their securities will incur capital losses.

Zero coupon bonds are more sensitive to interest rate swings than bonds which pay interest semiannually. In fact, depending on the maturity, price fluctuations of a zero coupon bond can be up to three times greater than those of an interest-paying bond. The longer the maturity, the greater the volatility. The key reason zeros are so volatile is that the interest payments are accumulated and compounded automatically at the bond’s stated yield. A bond which pays interest semiannually slowly loses its price volatility as it draws closer to maturity. Its true value to investors — interest — slowly dwindles as the number of interest payments left declines.

Call Provisions

Many municipal bond issues allow the issuer to call, or retire, all or a portion of the bonds at a premium or at par before maturity. When investors purchase bonds, dealers will quote the yield to call if it is less than the yield to maturity. Zero coupon municipal bonds containing call provisions typically provide that the bonds may be called at the option of the issuer on a specific date, not at par, but at a price or premium based on the compound accreted value of the security which was established at the time of issuance known as the original accretion rate.

Many state and local housing finance agency bonds and other bonds which are subject to special redemption provisions, as well as bonds which contain sinking funds, warrant careful attention since they may be called at any time.

Investors purchasing bonds at a premium in the new issue or secondary market should use care when paying prices in excess of an issue’s original accretion rate because a call may result in a lower- than expected yield or even a loss.

Click here for a Zero Coupon Bond Glossary.

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Copyright 2006. The Bond Market Association. Reprinted with permission.

Zero coupon bonds are more volatile than bonds that pay interest regularly.