T-Bonds (((Clipped Coupons))) - Good Investment Vehicle?

Question

Can anyone explain the advantages and disadvantages of purchasing Clipped Coupon Bonds (Zero Interest Bonds???) and placing them into an 401k account? Which ones make for a good investment based on a 5/10/15/20 years maturity?

Answer 1

Zero coupon bonds are good investment vehicles at the right time. That time may be now...

The key difference between normal bonds and the zero bonds is higher volatility to interest rate changes. Bonds are a bit tricky because there is an inverse relationship between interest rate and the price of bond. Zero bonds have rallied as of lately due to the weakening US economy with the consensus view that the US Fed will be cutting rates sometime in the middle of next year. When, how much and if rates will be cut next year is still up for debate.

The key advantages:
1) Investment does better than normal T-Bonds in a falling interest rate environment.

The key disadvantages:
1) Zeros do worse than T-Bonds in a rising interest rate environment.
2) Higher reinvestment risk. As opposed to having numerous times when you would otherwise be reinvesting the coupons, you are betting where interest rates will be once
3) Less liquid than T-Bonds, which means there may be a higher bid-ask spread on the bonds if you try to sell them before maturity.

As maturity lengths get longer (e.g. 15 instead of the 10), sensitivity to interest rate changes increases. The long duration (e.g. 20, 30) have significant interest rate risk. So it's a matter of how much risk you want to take on board.

So really the answer is yes, they can all be good investments - so long as you know what the risks are, when a good time to invest and what they are.

I hope that helps.