To understand fully how zero coupon municipal bonds work, it is important first to become acquainted with the principal characteristics of both municipal bonds and the zero coupon structure.
Zero coupon bonds were introduced to the fixed-income market in 1982. They were -- and are -- a unique concept in the marketplace.
While most municipal bonds provide semiannual interest payments, zero coupon bonds, as their name suggests, 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 bonds are sold at a substantial discount from the face amount. When a zero coupon bond matures, the investor receives the full face amount of the bond. For example, a bond with a face amount of $20,000, maturing in 20 years, may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,757 represents the interest. This example is based on an interest rate of 5.5% which compounds automatically until the bond matures: A $6,757.04 purchase of municipal zeros on January 1, 2002, due January 1, 2022, with a 5.5% original-issue yield and semi-annual compounding will be redeemed in 20 years for $20,000. The purchase will accrete as shown below on January 1 of each of the following years:
| 2007 | $8,862.88 | | 2012 | $11,625.01 | | 2017 | $15,247.96 | | 2022 | $20,000.00 |
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Types of Zero Coupon Bonds
The three largest categories of zero coupon securities available are zero coupon Treasury bonds, zero coupon corporate bonds and zero coupon municipal bonds. They are issued by the U.S. Treasury, corporations, and state and local government jurisdictions, respectively. Zero coupon Treasury bonds are generally considered the safest zero coupon bonds, backed by the full faith and credit of the U.S. government. Zero coupon corporate and municipal bonds offer a potentially higher rate of return commensurate with additional credit risk, which will vary based on the issuing entity. Only zero coupon municipal securities earn interest that compounds free from federal income tax and, in many cases, free of state and local tax as well.
Size of the Municipal Zero Coupon Market
The municipal zero coupon market is substantially larger today than it was in 1982, when there were 53 new offerings totaling $2.2 billion in issuance. During the first half of 2004, there were 179 new issues totaling $5.1 billion. More than $124 billion of zero coupon municipal bonds have been issued over the past ten years.
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