For those who are willing to forego coupon income in exchange for above-market yields, zero coupon municipal bonds 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. As such, they are ideal for retirement planning, educational funding and gifting.
An interesting variation of the zero-coupon concept is 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 Convertibles some of the best relative values in the entire muni market.