FastFacts: Treasury Zero Coupons

The basics: Treasury strips, commonly called Treasury zero coupons, are Treasury securities that have been stripped into their separate interest payments and principal components. When stripped, a Treasury note or bond is separated into as many components as there are interest and principal payments remaining on the security. For example, a 30-year bond (before the first interest payment), can be stripped into 61 separate securities – that’s 60 semiannual interest components, and one principal component.

After a security has been stripped, each of the separate components can be sold or traded individually to investors. The components of a stripped security are sold in a wide variety of maturities. The minimum par value of a component is $1000, with multiples of $1000.

How to buy: You can buy Treasury strips through financial institutions and brokerage firms. Zeros pay no interest until they mature, instead, you buy a Zero at a deep discount. Then the interest accumulates within the security until you redeem it at maturity for its face value. For example, a $1000 strip component with 30 years to maturity normally sells for less than $100, and pays $1000 at maturity. If you hold the component until it matures, your return is the difference between the purchase price and the maturity value.

Treasury zeros are useful investments when you want to be sure of receiving a certain amount of money at a specific date, such as for your child’s college education. Another plus: Because zeros don’t pay interest until they mature, you won’t have to worry about how to reinvest periodic dividends, as you would with regular bonds, and what rate you’ll earn on those reinvestments. It’s like the interest payments are automatically reinvested at a set rate, thereby guaranteeing that rate.

The risks: Treasury zeros are direct obligations of the Treasury. Therefore their value at maturity is backed by the full faith and credit of the United States. And Treasury zeros aren’t callable, so you don’t have to worry about finding a new investment before you’re ready.

If you buy a Treasury zero, plan on holding it until it matures. That’s because like other bonds, if you need to sell a Zero before maturity, you may get more or less than you paid for it because a bond’s market price fluctuates with changing interest rates. Furthermore, Zeros are even more volatile than standard types of bonds, because they pay no interest until the bond matures. So if interest rates rise, Zeros fall further in value than ordinary Treasuries.

Tax issues: Treasury zeros are free from state and local taxes. However, you have to pay federal taxes on the earned interest each year, even though you don’t receive it until the security matures. You’ll get a notice from your brokerage firm each year showing how much interest to report to the IRS. Reporting and paying federal tax on this so-called phantom income is one reason that taxable zeros are often put in tax-favored accounts such as IRAs, or held in custodial accounts for children in lower tax brackets.