For those who are willing to forego coupon income in exchange for above-market yields, zero coupon municipals merit strong consideration. Zero coupon bonds present a unique concept in the marketplace. While most municipal bonds provide semi-annual interest payments, zero coupon bonds have no coupon or periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.
Zero coupon municipal bonds combine the benefits of the zero coupon instrument with those of tax-exempt municipal securities and provide investors with the opportunity to lock in a particular rate of return, without having to worry about reinvestment risk or interest rates in the future. They are ideal for retirement planning, educational funding and gifting.
Another interesting variation of the zero-coupon concept are convertible bonds (CABS). These bonds start as zero coupon bonds and then, generally after eight to 15 years, convert to interest-paying bonds. CABS are ideally suited for individuals planning for retirement. During their working years, individuals can accumulate tax free capital that is ready for them when they retire. Then, upon retirement, they can receive the tax free income stream they need for living expenses.
The lack of demand from bond funds, which generally require coupon income on bonds they purchase, and their unique structure, have made zero coupons and CABS some of the best relative values in the entire muni market. They provide an excellent value in that they trade considerably cheaper than comparable coupon bonds. For those clients with money to invest and who are not in need of coupon income, consider muni zeros and CABS.