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Types of Bonds

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 Benefits

Because the interest paid by zero coupon municipal bonds is exempt from federal income taxes, these bonds provide returns that are often much higher on a net basis than comparable taxable securities. To see what a difference tax-exempt interest can make, turn to the Tax-Exempt/Taxable Yield Equivalents table.

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 sells a zero coupon municipal bond at a price that is higher or lower than the price at which it was purchased then, like any other fixed-income investment, there is a possibility of capital gain or loss.

Low Minimum Investment

Typically, zero coupon municipal bonds are typically sold in denominations of $5,000 face amounts. 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. Zero coupon bonds allow investors to invest 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 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.

Maturity

Zero coupon municipal bonds offer a wide choice of bonds. 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.

Credit 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 and Fitch Ratings (see Assessing Risk ). Some zero coupon municipal bonds carry insurance and are rated AAA. Credit ratings, however, should not be the sole basis for any investment decision.

Liquidity

If you want to sell your zero coupon bonds before they mature, you may do so in the secondary market at prevailing market prices (see Market Risk).

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.