THE STEADY STAPLES OF A WELL-BALANCED PORTFOLIO
ever, when the bond matures in 2018, you will receive the $10,000. However, if you were to sell the bond before it matures, you would realize a gain (or loss) if the sale price is more (or less) than your adjusted tax basis in the bond.
Any type of bond can be a zero-coupon bond. They don’t just have to be municipals or corporate bonds. The primary benefit of zeros to investors is that they can lock in current interest rates for the duration of the bond. Investors are attracted to zeros because they allow an investor to accumulate a fixed amount of money by a spec- ified date, lock in the current interest rate until maturity, and there is no call risk in most circumstances. But if you need current income before the bonds mature, you should consider purchasing bonds that pay current interest. Zeros may also be used for the long-term end of a bond portfolio since there is generally no call risk.
U.S. government zero-coupon bonds and corporate zero-coupon bonds (issued after July 1, 1982) are currently taxable as ordinary income to the investor even though the investor receives no current interest income from the bonds. The amount that is taxable is the annual amount of accrued original-issue discount. This is calculated by applying the bond’s yield to maturity to an adjusted issue price. Because taxable zeros cause the investor to pay taxes, they are gen- erally held in tax-qualified plans such as IRAs and qualified retire- ment plans. Holding zeros in these types of plans is beneficial to the investor because no tax is due on these until distributions begin.
Municipal zero-coupon bonds are, like other muni bonds, tax- exempt. For these bonds, accrued original-issue discount is not included in the investor’s gross income; it is tax-exempt. Therefore, municipal zeros are more frequently held in direct ownership by investors.
Discount Bonds Sometimes bonds sell on the open market at a price substantially less than their par value. These bonds aren’t to be confused with original- issue discount bonds, which are sold at a price that is less than their face value at the time of issue. This is usually the result of rising inter- est rates, which cause bond prices to fall. These bonds are referred to as “market discount bonds.” Investors like these bonds for many rea-