Assessing Risk

Credit Risk

Assessing credit risk is particularly important for zero coupon bonds since all your returns 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, 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.