Treasury zero coupon bonds are a special kind of Treasury for growth-oriented investors. Like T-bills, notes, and bonds, they are loans you make to the government. However, they pay no interest while the loan is outstanding. Instead, the interest accrues, and you get paid all at once, along with the return of your principal, at maturity. But be aware that zeros are federally taxed as if they did pay current interest. You must pay taxes annually all along the way, just as if you had actually received the interest payment, even though you don’t. The term “zero” refers to the fact that you receive no current income. Zeros are for the investor who does not need current income.
Your profits are locked in with zeros if you hold them to maturity. But there is another way to use zeros in your portfolio to make even more money. Between the dates you buy and sell your zeros, the value of the zeros in your portfolio fluctuates directly with long-term bond rates. If rates go up, zeros go down. If rates go down, the value of zeros goes up. It’s just that basic.
Zeros are for investors looking to invest both long-term to meet specific goals and in a shorter course of the business cycle to reap more immediate gains. Zeros are not for income investors, novice investors, risk-averse investors or Nervous Nellies. If you are the least bit hesitant, if you are short-term-oriented or green, if you can’t sleep like a baby because of the volatility, please do not consider zeros–they are not for you.
STRIPS (Separate Trading of Registered Interest and Principal Securities) are a type of zero coupon instrument. When I talk about zeros in Intelligence Report, I am talking about government-issued STRIPS. When purchasing STRIPS, I recommend you deal with an active, seasoned broker at one of the primary dealers in STRIPS–like UBS PaineWebber or Merrill Lynch. You can really take a thrashing on brokers’ commissions with zeros. Do not buy from a discount broker because they buy from a primary dealer themselves and add another markup to you. You will pay a front-end sales charge of 3%–5% and more with brokers who are not both primary dealers and active, seasoned pros in the zeros market.
In most cycles, I recommend short and intermediate maturities. In the past, I have used long STRIPS in my program but am unlikely to again. The 1980s and 1990s were most likely a once-in-a-lifetime play for long bonds. Please check the most recent issue for my up-to-the-minute advice on our current strategy.