Zero coupon municipal bonds combine the benefits of the zero coupon instrument with those of tax-exempt municipal securities and offer the following advantages: Tax Advantages
Because zero coupon municipal bonds offer the benefit of compound interest free from federal income taxes, they provide returns that are often much higher on a net basis than comparable taxable securities. To see what a difference tax-exempt interest can make, turn to the Tax-Exempt/Taxable Yield Equivalents table. Further, tax-exempt zero coupon municipal bonds earn interest that, in many cases, is also free from state and local taxes. (Certain out-of-state municipal bonds may be taxable at the state level. Check with your tax attorney or advisor.) In contrast, taxable zero coupon bonds are taxed each year on the amount of interest that has accrued for that year even though the accrued interest is not actually paid to investors in that year.
If an investor buys a zero coupon bond at other than the original offering or if the investor sells the bond before it matures, then, like any other fixed- income investment, there is a possibility of capital gain or loss.
Low Minimum Investment
Zero coupon municipal bonds are typically sold in denominations of $5,000 face amounts. But because they are sold at a substantial discount from face amount, you can purchase more zero coupon bonds for your money than other types of bonds. The greater the number of years a zero coupon bond has until maturity, the less you have to pay for it. Zeros allow investors to put aside a modest amount of money today and know exactly how much money they will receive on a specified future date.
Protection from Reinvestment Risk
Zero coupon municipal bonds 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. Investors in securities that pay interest semiannually may not always achieve a total realized compounded yield which is equal to the quoted yield to maturity they expected when they purchased their holdings. Depending on future prevailing interest rates, their interest payments may be reinvested in lower- or higher-yielding vehicles.
A Wide Choice of Bonds
An investor in zero coupon municipal bonds has a wide choice of investment vehicles. There are zero coupon municipal bonds available with maturities ranging from one to 40 years, with the majority of these bonds having maturities between eight and 20 years. There are also different types and grades of bonds from which to choose. The type you select will depend upon your reward objectives, risk tolerance and investment conditions.
Quality
The majority of zero coupon municipal bonds are rated A or better by the three major rating services: Moody's Investors Service, Standard & Poor's and Fitch Ratings (see Assessing Risk). Many zero coupon municipal bonds carry insurance and are rated triple-A. In short, safety-conscious investors will be able to enjoy a high degree of credit quality, depending on the particular issues they select.
Liquidity
Should you have to sell your zero coupon bonds before they mature, you may do so in a generally active secondary market at prevailing market prices (see Market Risk).
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