Zeros & STRIPS Offer Opportunity

Whether you buy a bond from Uncle Sam or Coca-Cola, the idea is basically the same. You hand them a sum of money and they make a regular interest payment called a coupon payment. When bonds were first issued, investors would tear off the ‘coupon’ from the bottom of the physical bond certificate and mail or bring that slip to their local bank for payment. Then when your bond matures, you get your initial investment back.

However, not all bonds operate this way.

As the name implies, zero-coupon bonds or Zeros don’t offer a regular interest payment. Rather than get their interest paid over the life of the bond, investors essentially get it all at the end. When buying a zero-coupon bond, investors purchase the bond at a discount to face value. When the bond matures, they are paid the face amount. A classic example of this is the traditional savings bond issued from the Treasury. For example, you may pay $25 to purchase a 20-year zero coupon bond with a face value of $50. After 20 years, you will get a check for $50.

Not all zeros start out as bonds without coupons. Separate Trading of Registered Interest and Principal of Securities, or STRIPS, are bonds that have been stripped of their interest payments and separated into two different securities—one that holds the coupons and the other the principal—each with separate CUSIPs. Financial institutions create STRIPS because they don’t necessarily want to wait 20 or 30 years to get their money back, but still want the steady income bonds provide.

Like the previous when-issued zero-coupon bond, investors purchasing STRIPS will receive no interest payments, but when it matures receive the face amount of the bond. And like before, STRIPS are sold at discounts to their face value. In the case of STRIPS, they often get deep discounts to their face values. Typically, investors will pay about $200 for a 30-year STRIPS worth about $10,000.

So, without the coupon payments of regular bonds, why would investors ever want to use Zeros or STRIPS in the first place?

For one thing, there are higher yields. Because of the long nature of these bonds, the discounts to face value can produce better yields and returns than buying a regular bond, collecting interest and holding it. Currently, a 10-year zero coupon bond offers a slightly better yield than a 10-year Treasury. Going out further on the maturity ladder, the difference is striking. Meanwhile, since most of these bonds are issued by the Treasury, credit quality is comparable.

Secondly, Zeros and STRIPS can be used to time future cash flows and purchases. For example, if an investor knows they need to pay for college in X years or have cash in retirement, a Zero can be purchased, held, and collected when investors need/want. This allows investors to push cash and guaranteed return into the future. That makes them a strong contender for long-term money and conservative investors.

Finally, zZeros and STRIPS are wonderful for speculation. Because of their long-term nature and discounts to face value, they tend to be very volatile in the short term. This is not a problem if you plan on holding them to maturity. But they can and do move a lot with regard to changes in interest rates. As such, they can have a leveraged effect when rates fall and increase in value by more than comparable Treasury bonds.

Given that zero coupon bonds can be useful for creating a guaranteed stream of cash/returns for a future date, investors looking to secure a portion of their savings should consider them. Buying them is as easy as logging into your brokerage account and making a purchase. Treasury and Federal agency-issued zero-coupon bonds and STRIPS are easily available at most major brokerages like Fidelity and Schwab. Likewise, traditional savings bonds—which are guaranteed to double after 20 years—can be purchased via TreasuryDirect.

However, it may be worth letting a professional do the buying. And in that there are numerous ETFs that track segments of the Zero/STRIPS markets. The Vanguard Extended Duration Treasury ETF (EDV), PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ), and iShares 25+ Year Treasury STRIPS Bond ETF (GOVZ) offer exposure to the segment. While not quite the same as buying a bond and holding it, investors can still benefit from the long-term nature of these bonds and higher yields. Keep in mind the ETFs will move as changes to interest rates occur.

All in all, zero-coupon bonds and STRIPS offer another way fixed income investors can profit and use bonds in their portfolios. Their unique attributes provide a different set of returns and that could be very helpful for portfolios.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.