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BASICS
How to Use Zero-Coupon Bonds

Zero-coupon bonds, known as zeros, are an excellent long-term investment when you know that you'll need to cash out at a particular date in the future, such as paying for a child's future college tuition bills. The only hitch is, you have to pay tax today on interest you may not see for years to come.

Bonds normally pay interest every six months. But zeros don't pay any interest at all until they mature, at which time they pay all accumulated interest at once.

Zeros come in denominations as low as $1,000 and are sold at discounts from face value of 50% to 75%, depending on how long you have to wait for maturity. A $1,000 zero yielding 6.15% and maturing in 20 years, for example, costs just $294.10.

Because it makes little sense to pay tax on income you haven't yet received, investors buy zeros mainly to keep in their individual retirement accounts, which allow tax-free buildup of earnings within the account.

Outside of IRAs, zero-coupon municipal bonds can be a good way to take advantage of the time value of money by paying 50 cents or so today to collect a dollar of face value some years down the road. Tax-free zeros are relatively rare, however, so you may have trouble finding ones that mature when you'll need the money. They usually can be called early, too, making their maturity dates even less reliable.

Zeros as a College Financing Tool

The tax consequences of zero-coupon bonds needn't be so onerous as they first appear if the bonds are used as a part of a college financing plan for young children. Buy the bonds in the child's name so that the income will be taxable to the child. Your broker can set up a free or low-cost custodial account. The first $750 of investment income a child reports each year is tax-free. For a child under age 14, the next $750 is taxed at his or her own rate, probably 10%, and investment income in excess of $1,500 is taxed at the parent's rate -- probably 27% or 30%.

The way the IRS requires zero-coupon bond interest to be reported works to your advantage. Consider a 6% zero that grows over 20 years from $312 to $1,000. You don't report one-twentieth of the $688 difference ($34) each year. Instead you report interest as it actually accrues. The first year, a $312 investment earning 6% compounded semiannually earns about $19. The second year, your investment would be $331 ($312 + $19), and $20 of interest would accrue. (You'll get a notice each year from the issuer or your broker showing how much interest to report to the IRS.) It would take quite a few years for the income to trigger much tax, even if you buy, say, ten bonds with a total face value of $10,000.

Choosing a Zero

The most popular zeros are those issued directly by the U.S. Treasury and their close cousins created by brokerage firms, who strip the income from regular Treasuries and sell the bare bonds. The direct Treasury issues are called STRIPS. The brokers' versions go by names like TIGRS and CATS. Beyond the security of having the federal government behind them, STRIPS are noncallable; they can't be paid off early if interest rates decline.

Zeros issued by corporations offer slightly higher yields than government zeros of similar maturities. Pay special attention to the ratings of corporate zeros; if the company goes broke, you may never get your money, or you may get only pennies on the dollar. Check for call features, too. If you consider any callable bond, be certain you understand when and at what price it can be called.

You can also buy zeros through a mutual fund. For example, the American Century Target Maturities Trust offers zero funds with several different maturity years. With such funds, you buy shares at a price that is expected to grow to $100 at the end of the target year. Although share prices can fluctuate day to day, if you hold on to your shares until the fund matures, you should earn the yield promised when you bought them. (American Century Target Maturities' minimum initial investment for regular accounts is $2,500; for custodial accounts and IRAs it is $1,000.)

Unless you buy shares in a fund, you'll need to use a broker to buy zeros. You may need more than one, in fact, to compare the availability and yields of bonds that fit your plans. Don't assume all STRIPS or broker-made Treasury zeros yield the same amount. Yields can vary with the commissions built into the price.

The search for tax-free zeros will be tougher. The supply isn't abundant and the call features can be troubling. You must find a broker willing to do the spadework to find appropriate bonds.

As an alternative, you could do your own spadework to find a mutual fund that finds the kinds of bonds you're looking for.