3/09/2015 - Zero-coupon bonds offer certainty
By Keith Lanton
Holding tax-free municipals to maturity can make otherwise skittish investors more confident
The only certain thing about investing is uncertainty. That theme was validated last year and humbled the wise men of Wall Street. Seventy-two out of 72 economists polled predicted that interest rates would rise. Yet the 10-year Treasury yield fell to 2.20% from 3.00%. In addition, none of the economists foresaw the price of oil tumbling to under $60 a barrel from $110, yet it did.
Are there any instruments that can help investors deal with the endemic insecurity of the financial markets? Zero-coupon tax-free bonds can be both a timely investment and provide certainty in an uncertain world. They are one of a handful of investments that grow and provide a fixed payoff at a specific date. In essence, zero-coupon bonds force the investor to accumulate wealth.
Moreover, including high-quality zero-coupon bonds in a portfolio may give otherwise skittish investors the confidence and comfort they need to increase their equity allocation, as well as the fortitude to ride out — or invest more in — a turbulent stock market.
THE MAGIC OF COMPOUNDING
Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … He who doesn’t ... pays it.”
A bonus that zero-coupon bonds offer in an environment of low interest rates is the absence of risk when investors hold the bond to maturity.
Interest earned on zero-coupon bonds is reinvested in the bond, and the interest rate of the reinvestment is the yield to maturity. The compounding continues until maturity, when the bondholder receives the face value of the bond.
Here is an example of the magic of compounding in today’s municipal bond market:
Invest $55,000 in a AA-rated, taxfree zero-coupon bond insured by INVESTMENT STRATEGIES Keith Lanton Berkshire Hathaway Assurance Corp. maturing in 18 years. At maturity, as long as the bond is solvent, the investor receives the face amount, or $100,000.The icing on the cake is that the investor owes no federal income tax on that growth. That represents a 3.70% federally tax-free yield to maturity. An investor in a high tax bracket would need to receive over 6% in a comparable taxable bond.
A TIMELY INVESTMENT
Zero-coupon tax-free bonds are also a timely investment. Intermediate and longer-term zero-coupon tax-free bonds are currently yielding about 20% more than comparable coupon-paying bonds.
Municipal bonds are the only segment of the bond market in the U.S. that is still dominated by retail investors. Low interest rates have disrupted the municipal bond market and divided bond investors into three distinct categories:
Yield hungry. Those who desperately seek high current income. They demand current coupons and in their quest for yield are reaching for longer-term and lower-credit-quality bonds.
Cautious. Those who remain committed to owning bonds but are very concerned about interest rates. They hide out in short-term bonds, waiting for rates to rise. They value portfolio diversification, crave the safety of bonds and want to earn a higher return than cash or the near-zero interest that money markets offer.
Throw in the towel. Those who think bond yields are too low and invest elsewhere. By and large, they have abandoned the bond market by liquidating their holdings and allocating that money instead to cash, dividend-paying stocks, real estate investment trusts and business development companies.
Intermediate to longer-term municipal zero-coupon bonds do not pay current income and do not offer short-term liquidity. Consequently, they are being neglected by yield hungry and cautious investors because of their inability to satisfy their needs. A combination of stable supply and low demand for zero-coupon municipal bonds is causing the yield of such bonds to be higher than those of comparable, coupon paying tax-free bonds.
Thus, for the right investor, zero-coupon tax-free bonds are a timely investment that provides certainty while forcing the investor to accumulate wealth through the magic of compound interest.
Keith Lanton is president of Lantern Investments, a New York based wealth management firm.