How Do Zero-Coupon Municipal Bonds Work?
-
What is a zero-coupon municipal bond?
-
A bond is a debt instrument, meaning that the issuer of the bond is borrowing a specified amount of money from you, often in multiples of $1,000. The investor buys a zero-coupon municipal bond at a deep discount off the face value, and the issue will pay the bond holder the face value of the bond when the bond matures. The difference between the purchase price and the face value of the bond equals the interest. Some bonds are callable, meaning the issuer can pay it back early if they choose. A benefit of zero-coupon municipal bonds is that you receive the entire investment back in one lump sum, which is helpful if you are saving for a particular event. A drawback is that you do not receive any income until the bond matures, but you are taxed on it if the interest is taxable.
What are municipal bonds used for?
-
A municipal bond, affectionately known as a muni, is issued by local, city or state government agencies to fund projects they do not have funds for in their budget, such as improving schools, roads and other public works projects. Most of them are exempt from local, state and federal taxes.
How do you buy zero-coupon municipal bonds?
-
When bonds are first issued, investors buy directly from the local, city or state government that is issuing it. The purchase can be made on the Treasury Direct website (see link below). From that point on, until the date of maturity, the bond can be resold on the bond market through a financial advisor or financial services company like E-Trade. The government agency must spend all of the money collected from the sale of bonds at once on the project the bonds were approved for within three to five years of the date of issuance of the bonds. The rate of the bond is the stated annual interest rate the issuer will be paying to the bond holder---the higher the rate, the higher the interest. The interest is deducted from the price of the bond at issuance and is realized when the issuer repays the bond holder the entire face value of the bond. Depending on the type of project funded by the bonds, the interest may be exempt from local, state and federal taxes.
What types of zero-coupon municipal bonds are there?
-
Municipal bonds can either be short term, maturing less than a year, or long term, which mature in longer than one year. Short-term bonds are either bond anticipation or tax revenue anticipation notes. Long term municipal bonds can be general obligation bonds, private activity bonds, revenue bonds or assessment bonds.
Are zero-coupon municipal bonds safe investments?
-
Municipal bonds, like any investment, vary in the amount of safety they offer the investor and nothing is guaranteed. The government agency issuing the municipal bond guarantees the bond, but the safety of the investment depends on the credit worthiness of the agency. The best way to determine whether a bond is a safe is to look at the rating of the bond. If a risk rating agency rates a bond as BBB, Baa or better, most people will consider the bond to be a sound investment. AAA-rated bonds are fully insured by the agency that issues the bond. Zero-coupon municipal bonds are very volatile when bought and sold on the open market, giving you the potential to either earn a profit or take a loss. However, if you purchase the bond directly from the issuer and hold it until maturity, the market volatility will not affect your investment.
-
