U.S.

Treasury zero-coupon bonds

Zeros with government backing to meet future needs
The power of compounding
The guaranteed rate of return on U.S. Treasury zeros can have a signicant multiplying effect on an investments value over time. This chart indicates the effect of compounding on a $10,000 investment at 5%. As you can see, the investment mathematically doubles in about 14 years, triples in about 22 years, and quadruples in about 28 years.1
$50,000

The U.S. Treasury market offers investors various options for investing in zero-coupon bonds, which provide the credit safety of the U.S. Treasury market and a way to meet future nancial needs. These investments typically appeal to growth-oriented individual and institutional investors.
Most investors purchase bonds or other types of xed-income securities for the regular interest payments these investments provide. Often, though, investors have a nancial need in the future, such as preparing for retirement, a childs education or a charitable contribution, but may not need regular income payments. Zero-coupon bonds provide a good way to pursue those goals. In addition, zeros offer investors the potential to generate capital gains if interest rates fall between purchase and sale. This piece will help explain how zero-coupon bonds grow over time, the potential benets and risk for investors, the types of zero-coupon Treasury bonds and the tax implications.

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What is a U.S. Treasury zero-coupon bond?

Unlike traditional, interest-bearing Treasury notes and bonds, a zero-coupon bond is sold at a discount from its face value. The issuer makes no interest payments during the life of the security. Investors receive the full face amount, which equals the initial investment plus accumulated interest compounded over the life of the bond.

30,000

20,000

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Who buys U.S. Treasury zero-coupon bonds?

0 14 22 28 32

Years held
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This information is hypothetical and is meant as an illustration only. It does not indicate a specific return or yield on any particular investment.

U.S. Treasury zeros offer the ability to plan for future needs like college tuition or retirement, so they appeal to individual investors. They offer investors the potential for growth. Investors interested in growth might appreciate the fact that zeros can rise in value as interest rates fall. U.S. Treasury zero-coupon bonds also appeal to institutional investors, like banks, mutual and pension funds, as well as foreign investors.

What are the tax implications?

The phantom interest on U.S. Treasury zero-coupon bonds is taxable as ordinary interest income every year, even though the holder receives no payment until maturity. Most U.S. Treasury zero-coupon bonds are exempt from state and local taxes, so they could be more appropriate for tax-advantaged retirement accounts or low-bracket custodial accounts. Keep in mind Wells Fargo Advisors is not a tax or legal advisor.

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What types and structures are available?

Many different structures are available in zero-coupon bonds, such as STRIPS, FICOs and REFCOs. STRIPS. Separate Trading of Registered Interest and Principal of Securities are direct obligations of the U.S. government and are available in book-entry form only. STRIPS are the most liquid type of zero-coupon security and therefore may be the most appropriate investment vehicle for clients interested in liquidity and preservation of principal. FICOs. These zero-coupon bonds are issued by the Financing Corporation, a government agency established by Congress and chartered by the Federal Home Loan Bank Board. FICOs are among the highest-yielding securities offered by U.S. government agencies and are a good choice for funding future needs like college or retirement. FICOs are an indirect obligation of the U.S. government and are not as liquid as STRIPS, but have an active secondary market. REFCOs. The Resolution Funding Corporation also issues zeros. Using U.S. Treasury securities as collateral, REFCOs offer investors attractive yields and were originally issued with extended maturities up to 40 years. REFCOs, like FICOs, are a good choice for funding future needs like college or retirement. However, they are not as liquid as STRIPS, so they may not be suitable for all investors.

Potential benets
Safety. U.S. Treasury and Agency zero-coupon bonds offer the credit quality and safety of principal offered by the U.S. Treasury market or its government-sponsored enterprises. These bonds carry an implied-AAA rating and offer investors ownership in part of an underlying Treasury note or bond, backed by the full faith and credit of the U.S. government. Zero-coupon bonds issued by agencies or enterprises of the U.S. government also carry an implied AAA rating.2 Potential for price appreciation. The prices of zero-coupon bonds move faster than traditional interest-bearing bonds. Investors may be able to benet when interest rates are declining but not when interest rates are rising. For example, a zero yielding 5.00% with a 20-year nal maturity would lose approximately 4.25% of its market value after one year if rates had risen to 5.50%. On the other hand, the same bond would gain 15.25% in market value if rates dropped to 4.50% in one year.2 It is important to remember that price uctuations will not affect the face value of the bond when held to maturity. Investors who hold their zeros until maturity are assured of receiving the face value of the bond, which represents the guaranteed rate of growth.3 Liquidity. The U.S. Treasury market, including zeros, is among the most liquid marketplaces today. Investors who need to sell their bonds before maturity can do so easily. Depending on current market conditions, the bonds may be worth more or less than the original purchase price.

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Only the timely payment of principal and interest is guaranteed.

Please note that accrued interest is paid at maturity, but is subject to taxes annually as ordinary income, even though no income will be received by the investor. The absence of a coupon payment causes zero-coupon bonds to uctuate in price more than interest-paying coupon bonds of similar maturity.
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 Flexibility. The U.S. Treasury zero-coupon market offers investors exibility in planning for the future through maturities ranging from one to 30 years. This allows an investor to match bonds with specic, future funding needs like college tuition or retirement. If, for example, you have a child who is two years old and you are planning for college tuition, you could buy a zero-coupon bond with a nal maturity of 16 years or you could purchase bonds maturing every year for four years, guaranteeing tuition payments for your child. And because zeros are issued at a deep discount to their face value, they offer a relatively low initial investment. Exemption from state and local income taxes. While U.S. Treasury zero-coupon bonds do not pay periodic interest, investors still pay taxes every year as if they were receiving the accrued income payments. This is known as phantom income and is taxed on the federal level. However, the phantom income is exempt from state and local taxes.

30-year zero-coupon Treasury bond value table

Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Maturity 8/15/09 8/15/10 8/15/11 8/15/12 8/15/13 8/15/14 8/15/15 8/15/16 8/15/17 8/15/18 8/15/19 8/15/20 8/15/21 8/15/22 8/15/23 8/15/24 8/15/25 8/15/26 8/15/27 8/15/28 8/15/29 8/15/30 8/15/31 8/15/32 8/15/33 8/15/34 8/15/35 8/15/36 8/15/37 8/15/38 8/15/39 3.0% 100 97.07 94.22 91.45 88.77 86.17 83.64 81.18 78.80 76.49 74.25 72.07 69.95 67.90 65.91 63.98 62.10 60.28 58.51 56.79 55.13 53.51 51.94 50.42 48.94 47.50 46.11 44.75 43.44 42.17 40.93 4.0% 100 96.12 92.38 88.80 85.35 82.03 78.85 75.79 72.84 70.02 67.30 64.68 62.17 59.76 57.44 55.21 53.06 51.00 49.02 47.12 45.29 43.53 41.84 40.22 38.65 37.15 35.71 34.32 32.99 31.71 30.48 4.5% 100 95.65 91.48 87.50 83.69 80.05 76.57 73.23 70.05 67.00 64.08 61.29 58.62 56.07 53.63 51.30 49.07 46.93 44.89 42.93 41.06 39.28 37.57 35.93 34.37 32.87 31.44 30.07 28.76 27.51 26.31 5.0% 100 95.18 90.60 86.23 82.07 78.12 74.36 70.77 67.36 64.12 61.03 58.09 55.29 52.62 50.09 47.67 45.38 43.19 41.11 39.13 37.24 35.45 33.74 32.11 30.57 29.09 27.69 26.36 25.09 23.88 22.73 5.5% 100 94.72 89.72 84.98 80.49 76.24 72.21 68.40 64.79 61.37 58.13 55.06 52.15 49.39 46.79 44.31 41.97 39.76 37.66 35.67 33.79 32.00 30.31 28.71 27.19 25.76 24.40 23.11 21.89 20.73 19.64 6.0% 100 94.26 88.85 83.75 78.94 74.41 70.14 66.11 62.32 58.74 55.37 52.19 49.19 46.37 43.71 41.20 38.83 36.60 34.50 32.52 30.66 26.10 27.24 25.67 24.20 22.81 21.50 20.27 19.10 18.01 16.97 6.5% 100 93.80 87.99 82.54 77.42 72.63 68.13 63.91 59.95 56.23 52.75 49.48 46.41 43.54 40.84 38.31 35.94 33.71 31.62 29.66 27.82 28.90 24.48 22.96 21.54 20.21 18.95 17.78 16.68 15.65 14.68 7.0% 100 93.35 87.14 81.35 75.94 70.89 66.18 61.78 57.67 53.84 50.26 46.92 43.80 40.88 38.17 35.63 33.26 31.05 28.98 27.06 25.26 23.58 22.01 20.55 19.18 17.91 16.71 15.60 14.57 13.60 12.69

Returns shown are illustrative only and exclude dividends, taxes and commissions.
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Summary
U.S. Treasury zero-coupon bonds can be a valuable addition to your xed-income portfolio. Your Financial Advisor with Wells Fargo Advisors can help you determine whether these securities t your investment objectives and risk tolerance and which types may best suit your investment needs. To get started, talk with your Financial Advisor today.

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