By Keith Lanton
Zero-coupon tax-free bonds may offer the best investment opportunity in today’s fixed-income market. Intermediate- and longer-term tax-free zeros are currently yielding about 20% more than comparable coupon-paying bonds. For example, an investor in a high-tax state can earn 3.50% to 3.75% on a 20-year tax-free muni. A client in a high federal and state tax bracket could see a tax-equivalent yield of 7.00% to 7.50%.
With interest rates at or near historic lows, munis represent the only segment of the U.S. bond market still dominated by retail investors. For advisors wondering whether zero-coupon munis are appropriate for their clients, it may be helpful to remember that the enduring low-rate environment has segmented bond investors into three distinct categories:
- Yield-hungry investors are desperately seeking high current income. In their quest for yield, these clients favor longer-term and lower-credit-quality bonds. The demand has narrowed the yield premium between lower-rated and higher-rated coupon-paying bonds, also shrinking the spread between income-producing shorter-term and longer-term bonds.
- Cautious investors remain committed to owning bonds but are very concerned about the possibility that interest rates will rise. They value portfolio diversification, crave the safety of fixed income and want to earn a higher return than the near zero currently offered by cash or money markets. Consequently, they have parked assets in short-term bonds with the intention of rolling them over at higher yields once interest rates begin to rise.
- Throw-in-the-towel investors have abandoned the bond market because of its low yields. They are allocating the assets formerly in bonds to cash, dividend-paying stocks, real estate investment trusts (REITs) and business development companies (BDCs).
Together, these investor types have created a market dynamic that makes zero-coupon tax-free bonds a compelling option. First, intermediate to longer-term municipal zero-coupon bonds do not pay current income and do not offer short-term liquidity. Consequently, they don’t satisfy the needs of either yield-hungry or cautious investors. With bond supply unchanged and investor demand falling, yields on zero-coupon municipal bonds are significantly higher than those on comparable coupon-paying tax-free bonds.
A bonus in the low-interest-rate environment is that interest earned on zero-coupon bonds is reinvested back into the bond, and the interest rate of the reinvestment is the yield to maturity. In essence, investors are forced to accumulate wealth as their initial principal earns interest that is reinvested. At maturity, the bondholder receives the face value of the bond.
By contrast, a client who purchased at par a 4% coupon bond with a face amount of $100,000 would receive $2,000 every six months. Although yield to maturity assumes that each $2,000 payment is reinvested at 4%, in reality, the investor will almost certainly earn near zero on the coupon payments. Therefore, the true compounded yield to maturity would be meaningfully lower than 4%.
The icing on the cake with zero-coupon tax-free bonds is that income and growth are tax-free. Under current law, the interest income from municipal securities is exempt from federal income taxes. In most states, interest income received from securities issued by governmental units within the investor’s own state is also exempt from state and local income taxes.