Last week, we began a discussion of possible reactions to recent substantial increases in interest rates. The Federal Reserve (FED) has been pumping up rates in a quest to stifle rampant inflation, which (ironically) was not caused by low-interest rates. Any time substantial interest rate changes occur, there will be economic winners and losers, depending on both individual situations and reactions.
Indications are that we have nearly reached the high point in this interest rate cycle. With this understanding, we are looking today at a lesser-known fixed-income (bond) investment. Most people react negatively to any mention of bonds. In our financial planning practice, we frequently hear people say, “I hate bonds.” Understanding some basic concepts and characteristics of certain types of bonds will clear the air as to their purpose and importance in portfolio construction, management, and success.
Bonds are debt instruments, as opposed to equity instruments (stocks). They can be issued by governments or other organizations, and come in many flavors, so to speak. Today we are looking at Zero Coupon Bonds (Zeroes), so named because they do not pay interest until maturity. Instead, they are purchased at a discount, and upon maturity are redeemed at face value.
Prior to maturing, all bonds have market values, determined in the secondary, or resale, market. The easiest way to depict bond price action is to picture a seesaw, with bond prices on one end, and interest rates on the other. When one goes up, the other reacts by going down, and vice-versa. The magnitude of the change in market price reflects time to maturity. Longer maturities incur more volatility than short-term bonds. With interest rates set to decrease sometime in the foreseeable future, long-term bonds are currently priced low. But Zeroes are the most volatile of all bonds and are presenting a golden opportunity to leverage future interest rate decreases.
A primary setback for owners of Zeroes involves the mismatch between interest credits versus payments. Owners receive imputed interest, but no cash is paid. In taxable accounts, this creates a tax liability, without the corresponding cash inflows until maturity. Ingenuity indicates that owning Zeroes in tax-deferred, or even tax-free, accounts, defers any tax liability until the funds are withdrawn from the account. In the case of Roth IRAs, no tax will ever be due on imputed interest, changes in market value, or maturity, if held that long.
Zeroes can be purchased individually or using ETFs designed especially for the purpose. We prefer Government Zeroes to minimize long-term risk.
Portfolio planning is part science and part art form. Finding a qualified investment advisor is always a good start. Look for the CFPâ designation.
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