There are analysts who believe interest rates are going to fall much lower over the next several months and remain there for quite a while.
In a time of declining interest rates, when bonds do well, zero-coupon bonds can produce particularly good returns. A zero-coupon bond is a fixed-income security that makes no interest payments. Instead, it is sold at a discount from face value; when it matures, it is worth the face value. As rates decline, the locked-in return looks particularly attractive.
The bond's maturity and credit quality as well as prevailing yield levels determine the discount.
One well-known zero is a Treasury bond where the interest-bearing portion of the bond is sold separately from the principal. An eight-year stripped Treasury zero, which is just the principal portion of the bond, sells at around $522 per $1,000 bond; a 13-year stripped bond sells at around $340; and a 17-year sells at around $248. There are many other types of high-quality zeros available that offer a higher return. Most come in $1,000 minimums.
Some are exempt from state and local taxes, just as the stripped Treasuries are. But these and all other taxable zeros are subject to federal income tax. The Internal Revenue Service requires that you pay tax on income you accrue each year even though you don't get the money until maturity. However, there are two corporate bonds (GMAC debentures due in 2012 and 2015 and Exxon Shipping debentures due in 2012) where the taxes may be deferred until the bonds are sold or mature.
No federal taxes are paid on tax-exempt zeros. One recent municipal zero issue is the City and County of Denver, Airport System Revenue, capital appreciation bonds. They are noncallable, due in 2004 and sell for around $325 per $1,000 bond. Yield to maturity is about 8 percent. Because of credit considerations concerning the airlines that will use the airport, Moody's Investor Services Inc. gives the bonds a Conditional Baa1 rating, while Standard & Poor's Corp. gives a BBB rating.