When it comes to zero coupon bonds ("zeroes"), investing in a mutual fund or exchange-traded funds, rather than individual bonds, presents investors with a different set of risks and rewards. While owning an individual bond usually means there is a high likelihood you will receive the expected return upon maturity, funds – while more diversified – offer no such guarantee.
Zero Coupon Bonds: A Review
First, let’s take a brief look at zeroes themselves. Rather than paying interest like a traditional bond, zeroes are issued at a price discount to their full value at maturity, and their prices gradually rise until they become fully valued on their maturity date. For example, the zero-coupon bond could be issued at $80 and it slowly increases in price to $100 throughout its life. This process doesn’t occur in a straight line, however. Zero-coupon bonds are much more sensitive to changes in prevailing interest rates than plain-vanilla coupon-bearing (i.e., interest-paying) bonds, so they tend to be highly volatile.
The longer the time until maturity, the more volatile the security. As the maturity date grows closer, the bonds become less volatile.
The key point here is that while volatile in the short term, the bonds ultimately mature at their full value. As a result, an investor in an individual zero-coupon bond has the assurance that even if the value of the bond is dropping in the short term, there is no principal risk as long as he or she can hold the bond until its maturity.
Zero Coupon Bond Funds: No Maturity Date Means Higher Risk
This isn’t the case with zero-coupon mutual funds or exchange-traded funds (ETFs). Such funds typically do not mature unless they are a specifically-designated “target date” fund with a set maturity date. As a result, zero-coupon bond funds are exceptionally volatile but they carry no guarantee that an investor will finish with his or her principal fully intact. Investors in these funds therefore need to be aware that they are assuming a high level of principal risk for a yield that, in most cases, is low for an investment with elevated volatility.
Zero Funds Aren't Appropriate for Specific Goals
One benefit of individual zeroes is that investors can target a specific amount of money to be returned on a certain date. For instance, a person who was saving for college could purchase zero-coupon bonds that mature in the year that a payment is due. Zero-coupon bond funds offer no such option. Because the funds are so volatile, investors should treat them like stock funds: consider them for long-term goals, but avoid them if you need the money in less than three years. This is especially true now, with rates so low that there is more downside risk than upside potential.
Zero Coupon Bond Funds Work as Trading Vehicle
Having said this, zero-coupon bond funds can be useful for investors who know what they’re getting into. Since they are so responsive to moves in prevailing interest rates, they can generate substantial returns when interest rates are falling and prices are rising. (Keep in mind, prices and yields move in opposite directions.)
For example, in the period from July 25, 2011, through September 19, 2011, the yield on the 30-year Treasury bond fell from 4.32% to 3.19% - an enormous move in such a short period of time. During that same interval, the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ticker: ZROZ) produced an outstanding gain of 38.7%. As a result, funds such as these are appropriate only for the most sophisticated investors.
The Bottom Line
Zero-coupon bond funds can be an excellent way for highly knowledgeable traders to take advantage of large moves in the bond market – providing they get their timing right. Funds such as ZROZ are also a favorite of those who are looking for a way to bet against the bond market. However, less sophisticated investors need to look carefully at these funds to make sure they understand the risks.
Zero Coupon Bonds: A Review
First, let’s take a brief look at zeroes themselves. Rather than paying interest like a traditional bond, zeroes are issued at a price discount to their full value at maturity, and their prices gradually rise until they become fully valued on their maturity date. For example, the zero-coupon bond could be issued at $80 and it slowly increases in price to $100 throughout its life. This process doesn’t occur in a straight line, however. Zero-coupon bonds are much more sensitive to changes in prevailing interest rates than plain-vanilla coupon-bearing (i.e., interest-paying) bonds, so they tend to be highly volatile.
The longer the time until maturity, the more volatile the security. As the maturity date grows closer, the bonds become less volatile.
The key point here is that while volatile in the short term, the bonds ultimately mature at their full value. As a result, an investor in an individual zero-coupon bond has the assurance that even if the value of the bond is dropping in the short term, there is no principal risk as long as he or she can hold the bond until its maturity.
Zero Coupon Bond Funds: No Maturity Date Means Higher Risk
This isn’t the case with zero-coupon mutual funds or exchange-traded funds (ETFs). Such funds typically do not mature unless they are a specifically-designated “target date” fund with a set maturity date. As a result, zero-coupon bond funds are exceptionally volatile but they carry no guarantee that an investor will finish with his or her principal fully intact. Investors in these funds therefore need to be aware that they are assuming a high level of principal risk for a yield that, in most cases, is low for an investment with elevated volatility.
Zero Funds Aren't Appropriate for Specific Goals
One benefit of individual zeroes is that investors can target a specific amount of money to be returned on a certain date. For instance, a person who was saving for college could purchase zero-coupon bonds that mature in the year that a payment is due. Zero-coupon bond funds offer no such option. Because the funds are so volatile, investors should treat them like stock funds: consider them for long-term goals, but avoid them if you need the money in less than three years. This is especially true now, with rates so low that there is more downside risk than upside potential.
Zero Coupon Bond Funds Work as Trading Vehicle
Having said this, zero-coupon bond funds can be useful for investors who know what they’re getting into. Since they are so responsive to moves in prevailing interest rates, they can generate substantial returns when interest rates are falling and prices are rising. (Keep in mind, prices and yields move in opposite directions.)
For example, in the period from July 25, 2011, through September 19, 2011, the yield on the 30-year Treasury bond fell from 4.32% to 3.19% - an enormous move in such a short period of time. During that same interval, the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ticker: ZROZ) produced an outstanding gain of 38.7%. As a result, funds such as these are appropriate only for the most sophisticated investors.
The Bottom Line
Zero-coupon bond funds can be an excellent way for highly knowledgeable traders to take advantage of large moves in the bond market – providing they get their timing right. Funds such as ZROZ are also a favorite of those who are looking for a way to bet against the bond market. However, less sophisticated investors need to look carefully at these funds to make sure they understand the risks.