Diversify your portfolio with zero coupon bonds

I want to use bonds in my portfolio to diversify away from equities as I approach retirement, but I don’t need any current income. Are there bonds that don’t generate annual income?

The baby boomer generation, in particular, appears to be well-focused on attaining and maintaining a comfortable retirement standard of living but remains concerned about the fluctuations in the equity markets, in which they are heavily invested. As a complement to their portfolios, many boomers are increasing their bond holdings in an effort to add diversification and reduce their overall risk exposure. Caution needs to be exercised, however, as many investors are under the misunderstanding that bonds cannot lose principal value.

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From the moment a bond is purchased, it is subject to market fluctuation. A prime cause of the fluctuation is often attributable to overall changes in interest rates. As a general rule, bonds move inversely with interest rates. If interest rates go higher, bond prices decrease, and conversely, they go up in value as interest rates decrease.

Other bond investment risks include “credit risk,” which rating agencies define as the ability of the issuer to pay back interest as well as principal. Beyond credit and market risk, there is also the risk that the issuer will “call” the bond prior to maturity at a pre-stated value.

If there is no current income needed from the bond portfolio, but you still want that exposure to bonds, you may want to consider utilizing a portfolio of zero coupon bonds. Zero coupon bonds are debt instruments issued at a discount to their face value, make no interest payments, and pay face value at time of maturity.

For example, let’s look at a hypothetical zero coupon bond issued today at a discount price of $743 with a face value of $1,000, payable in 15 years. If you buy this bond, hold it for the entire term, and receive the face-value payment, the difference of $257 represents the interest you earned. In this hypothetical example, the bond's interest rate would amount to approximately 2%.

Next: "Zero coupon bonds are predominantly issued by the federal government and typically have maturities of 10 to 15 years"

Zero coupon bonds are predominantly issued by the federal government and typically have maturities of 10 to 15 years. Zero coupon bonds are traded on recognized financial markets and exchanges, which may offer investors liquidity in the event they choose not to hold them to maturity. Like other bonds, their market value will fluctuate with changes in interest rates. As rates rise, the value of existing bonds typically fall. If an investor sells a bond before maturity, it may be worth more or less than the initial purchase price. By holding it to maturity, an investor will receive the face value of the bond, barring default by the issuer.

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In general, investments seeking to achieve higher yields also involve a higher degree of risk. U.S. Treasury zero coupon bonds are guaranteed by the federal government as to the payment of principal and interest. However, if you sell a Treasury zero coupon bond prior to maturity, it could be worth more or less than the original price paid.

One of the biggest risks of zero coupon bonds is their sensitivity to swings in interest rates. In a rising interest rate environment, their value is likely to fall more than other bonds. Additionally, zero coupon bonds are subject to an unusual taxation in which the receipt of interest is imputed each year, requiring holders to pay income taxes on what is called "phantom income."

For individuals, zero coupon bonds may serve as an additional diversification tool within their portfolio. In addition, they may be bought to fund specific future financial obligations. By investing the money in a U.S. Treasury zero coupon bond, an investor can be assured that the funds will be fully intact to meet this liability.

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As with any investment, a zero coupon bond's appropriateness hinges on your individual needs and circumstances. Understanding some of the basic concepts may help you better assess whether they might have a place in your portfolio.

Next: What is a donor-advised fund?

What is a donor-advised fund?

A donor-advised fund, or DAF, is a charitable giving vehicle sponsored by a public charity that allows you to make a contribution to that charity and be eligible for an immediate tax deduction, and then recommend grants over time to any Internal Revenue Service-qualified public charity.

When you donate to your donor-advised fund, you're making a tax-deductible donation to the organization sponsoring the fund. But because your account is a donor-advised fund, you advise the organization on how to grant the money out to your favorite charities. Your donation is also invested based on your preferences, so it has the potential to grow, tax-free, while you're deciding which charities to support.
 

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Send your questions about estate planning, retirement, and investing to Joel M. Blau, CFP, c/o Urology Times, at UT@advanstar.com. Questions of general interest will be chosen for publication. The information in this column is designed to be authoritative. The publisher is not engaged in rendering legal, investment, or tax advice.

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