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Zero Coupon Municipal Bonds

Updated on November 22, 2010

For investors seeking tax free investments that are safe and offer portfolio diversification, zero coupon municipal bonds may be just the right financial instrument. As the name implies zero coupon municipal bonds combine the unique no interest / high discount characteristics of a standard zero coupon bond with the tax shelter advantages offered by municipal bonds.

The basics of zero coupon municipal bonds

A zero coupon bond does not pay annual interest like a standard debenture bond. This means these bonds are highly discounted when sold. This does not mean that the holder does not pay interest taxes, however. There is a "phantom" income that is taxed in the form of imputed interest. Even though the holder receives no interest income, taxes are still paid as if he did.

Likewise, a standard municipal bond does pay annual interest and this interest is non-taxable at the federal level. It may also be tax exempt on the state and local level depending upon certain circumstances. This tax savings are the principal reason that munis are an attractive investment for many investors.

Advantages of zero coupon municipal bonds

The ability to purchase a fixed rate investment with substantial tax advantages at a highly discounted rate is very attractive and is the key advantage of zero coupon municipal bonds. A younger investor or those on a fixed income can leverage their investment dollar with these bonds. Because no interest is paid annually, the bonds are discounted highly from face value. Depending upon maturity date many of these bonds can be bought for ten or twenty cents on the dollar. To guarantee a fixed return for a low up front cost can help many people plan for the future.

These zero coupon munis also have a built in level of comfort that stocks generally cannot offer. Not only is the return safe since many municipal bonds are issued by large corporations, cities or governments, but there are many companies that evaluate and provide ratings for these bonds. Morningstar and Standard & Poore are just two companies that provide rankings for zero coupon municipal bonds.

The value guaranteed upon maturity means less stress for the investor as the market fluctuates wildly. Unless the issuer fails, the investor truly gets what he pays for. The ability to avoid temptation and play market swings means better long term result for the holder of bonds versus the stock investor.

If a holder of a zero coupon municipal bonds needs money before maturity, there are secondary markets where the bond can be sold. This is rarely a good choice, but many investors do like knowing there is a certain level of liquidity in their portfolios at all time.

Zero Coupon Municipal Bonds Considerations

Zero coupon municipal bonds can leverage cash investments
Zero coupon municipal bonds can leverage cash investments

It is always wise to speak with a municipal bond broker to learn what can go wrong in the bond market. Zero coupon municipal bonds can become problematic if the issuer fails to follow set guidelines which establish the tax status of the bonds. The purchaser in rare cases may be held responsible for taxes on what are supposed to be tax free bonds. The uncertainty of selling price if the bond has to be sold before maturity is another thing to consider. Again, most bondholders are hold-to-maturity investors unless the are buying short term Treasure bills. Education is the key just as it is with every investment type.

Zero coupon municipal bonds can be a great way to diversify and plan for retirement. The ability to leverage investment dollars in a tax exempt instrument make these bonds well worth a look. Safety and consistent yield will appeal to many older or conservative investors. A discussion with a financial advisor is a must before diving into the zero coupon municipal bonds market.


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