# Zero Coupon Bonds

S

#### Shhhh

Hello all,

How do Zero Coupon Bonds work...

earlier in March we had a discussion about regular bonds and you kind folks
and I think I have a decent idea whats going on there, but these seem to be
different animals?

This example is from the JB Hanauer website...

Coupon: 0.00
Yield: 3.99
Price: 87.974
oid Yield: 6.55
Maturity: 8/1/2009

assuming I buy \$10,000 face value I'd spend \$8,861.60 today to buy these
bonds. Where I'm lost is how do I figure out how much I'll be paid
annually/semiannualy, at end of maturity? am I over thinking it? is it as
simple as 10,000 - 8,861.60 = 1,138.40?

Thank you all for your kind help and guidance!,
Shhhh

J

#### joetaxpayer

Shhhh said:
Hello all,

How do Zero Coupon Bonds work...

earlier in March we had a discussion about regular bonds and you kind folks
and I think I have a decent idea whats going on there, but these seem to be
different animals?

This example is from the JB Hanauer website...

Coupon: 0.00
Yield: 3.99
Price: 87.974
oid Yield: 6.55
Maturity: 8/1/2009

assuming I buy \$10,000 face value I'd spend \$8,861.60 today to buy these
bonds. Where I'm lost is how do I figure out how much I'll be paid
annually/semiannualy, at end of maturity? am I over thinking it? is it as
simple as 10,000 - 8,861.60 = 1,138.40?
A zero coupon bond is just that, it's has no coupon. No payments until
maturity. Just the face value at the end of the term (barring any call
provision). Because of this, they would always sell at a discount
representing the yield.
Your math is right, you get back the \$1138.40 on your \$8861.60
investment. This is 12.85% return over 35 months. About 4.29%/yr.
(days to maturity = 1050.65, this is 2.877 years. (1.1285^(1/2.877))=1.0429

You must decide if 4.3% is good for you. (depends on how this is taxed)
JOE

S

#### Shhhh

here's a followup if you all don't mind...
If I am looking for a safe long term investment, and my county is offering
long term 0 coupon bonds that mature in 2032. I can get 100 bonds today for
\$31,538... so when the bond matures I'd recieve the entire \$100,000 face
value (assuming the counties AAA rating is correct, and they pay their
obligations). That would essentially mean I would be averaging 8.35% per
year.

This seems like a decent rate of return to me. it might not match the
average return of the stock market, but at least in my mind this is a safer
investment.

Thanks,
Shhhh

joetaxpayer said:
A zero coupon bond is just that, it's has no coupon. No payments until
maturity. Just the face value at the end of the term (barring any call
provision). Because of this, they would always sell at a discount
representing the yield.
Your math is right, you get back the \$1138.40 on your \$8861.60 investment.
This is 12.85% return over 35 months. About 4.29%/yr.
(days to maturity = 1050.65, this is 2.877 years.
(1.1285^(1/2.877))=1.0429

You must decide if 4.3% is good for you. (depends on how this is taxed)
JOE

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J

#### jIM

If I am looking for a safe long term investment, and my county is offering
long term 0 coupon bonds that mature in 2032. I can get 100 bonds today for
\$31,538... so when the bond matures I'd recieve the entire \$100,000 face
value (assuming the counties AAA rating is correct, and they pay their
obligations). That would essentially mean I would be averaging 8.35% per
year.

This seems like a decent rate of return to me. it might not match the
average return of the stock market, but at least in my mind this is a safer
investment.

http://smartmoney.com/university/glossary/index.cfm?letter=Z
http://smartmoney.com/university/investing101/bonds/index.cfm?story=types#zero

Locking in 8% return for short amounts of time is a good thing.
Locking it in for 25 years, the return might be taken away because of
inflation. Do you have other investments other than these bonds?

E

#### Elle

Shhhh said:
my county is offering long term 0 coupon bonds that mature
in 2032. I can get 100 bonds today for \$31,538... so when
the bond matures I'd recieve the entire \$100,000 face
value essentially mean I would be averaging 8.35% per
year.
Isn't it (100,000/31538)^(1/(2032-2006)) = 1.0454, or about
a 4.5% return per year?

I do not think bonds with maturities over about five years
are prudent for any investor, young or old. Especially when
the bond yield curve is inverted (or nearly so), as it is
now. Especially with current yields still on the low side,
compared to historic yields. As Jim hinted, what are your
goals with this investment? With a 25+ year timeframe, I'd
put the money in a dividend achieving stock mutual fund or
similar. Right now, you'd likely pay only the 15% dividend
tax rate on the dividends.

S

#### Shhhh

Thank you both for your kind replies... Jim and Elle, yes I have other
savings... I'm fully invested in my ROTH IRA, my wife contributes the max to
her 401k., and I have mutual fund and stock accounts that contribute to my
overall portfolio. The thing I like about bonds is the "guaranteed return" I
KNOW, assuming the company or municipality stays "liquid" I will recieve
"\$X" from this investment. Considering I believe the stock market is
incredibly over valued right now, this aspect apeals to me.

I have no desire to flip or trade these bonds... I think of it as money
under the mattress that is growing a pre-determined steady clip.

As far as inflation is concerned I had not really taken that part into
account... what is the historical rate of inflation over the past 5/10/15
etc. years?

and please keep the fantastic info comming!

Thanks,
Shhhh

J

E

#### Elle

Considering I believe the stock market is
incredibly over valued right now, this aspect apeals to
me.

I have no desire to flip or trade these bonds... I think
of it as money
under the mattress that is growing a pre-determined steady
clip.
The stance of academia's Robert Shiller may further bolster
http://cowles.econ.yale.edu/news/shiller/rjs_02-05-bloomberg_shil-sieg.htm .
usingTreasury Inflation-Protected Securities (TIPS) in your
portfolio, if you haven't heard of them before.

E

#### Elle

joetaxpayer said:
Shhhh wrote:
what is the historical rate of inflation over the past
5/10/15
etc. years?
http://www.westegg.com/inflation/ will give you that data.
Shiller's oft-quoted data as well as another calculator at
http://data.bls.gov/cgi-bin/cpicalc.pl both corroborate the
site above. They're undoubtedly all using the same CPI data.
For fun, annualized, starting from the last full year (=
2005), the 5/10/15 year period inflation rates were about
1.9%/2.2%/2.4%. I do personally view the CPI with some
circumspection these days. I own my home outright, for one,
so the CPI does not reflect the inflation of my expenses
very well.

T

Shhhh said:
I have no desire to flip or trade these bonds... I think of it as money
under the mattress that is growing a pre-determined steady clip.
As Elle pointed out the interest rate is 4.54%, not 8.38% - that's a big
difference!

And one down-side of a zero-coupon bond is that it has the highest
interest rate risk of any type of bond, because you have to wait out the
entire period until redemption before it actually spits money back at
you. Interest rate risk is the risk that interest rates will rise during
the period you're holding the bond. If that happens, your bond could
drop quite a bit in value, and you'd be missing out on the higher rates
that are available.

to you after 26 years -- a return of 4.54% per year.

Roll forward three years to 2009 and it will be a 23-year bond, right?
Let's say the prevailing interest rate on this type of bond had risen to
5.5%, which is not far-fetched, because it wasn't all that long ago that
you could find muni strips paying 5.5%.

Your bond would be worth...\$29,187 at that point, almost \$2,000 less.
Why? Because your bond's market price will adjust to the point where it
yields the same 5.5% as competing bonds do. If you invest \$29,187 at
5.5% for 23 years, you end up with \$100,000. So if you went to sell the
bond at that point, you'd expect to get somewhere around \$29k -- you'd
have lost money, after 3 years holding the investment. You could make
money this way too (if rates fall below 4.54% the bond would rise in
value) but the point is, this is a risk you take on with a long-term
strip, that isn't present to nearly the same degree with shorter-term bonds.

If you are absolutely, postively, sure that you won't need to sell the
bond until redemption in 2032 (including: you'll live that long, won't
have a disability, won't want to buy a Grady White, etc etc) there's
also inflation risk, as others have mentioned. That 4.54% might amount
to "treading water" or even losing money in real terms. You're loaning
money out and agreeing to a locked-in 4.54% annual rate of interest. Is
that enough for you, enough compensation for the risk of inflation being
high at some point in the next 26 years?

The other question is whether to bother with a municipal bond at all --
that depends on your tax bracket over the next 26 years. Though these
days taxable long-term bonds aren't much better than that 4.5% you're