I was recently looking into zero-coupon bonds as a means of diversifying my portfolio. My knowledge of bonds is fairly basic, so I need a handle on what's a solid move for someone in his mid-20s who wants to add bonds to his portfolio. With the market becoming increasingly volatile, I want to lock in a steady return. Basically, should I be considering a zero-coupon bond fund, or maybe buy a zero straight up? -- Patrick McNamara

Patrick,

There are four basic principles investors need to understand about zero-coupon bonds and bond funds.

First, they are the most interest-rate-sensitive bonds you can buy. What does this mean? It means that compared with coupon-bearing bonds of the same maturity, zero-coupon bonds will rise or fall in price more in response to changes in interest rates. So if interest rates rise by 100 basis points, the price of a five-year zero-coupon bond will fall more than the price of a five-year bond that carries a coupon. Likewise, if interest rates fall by 100 basis points, the zero will rise in price more than the coupon bond.

Why is this so? Because when you buy a zero-coupon bond, there is no reinvestment risk. Reinvestment risk is the risk that when coupon income gets paid on a bond, interest rates will have dropped, and the coupon income will have to be invested at a lower interest rates. No coupon income, no reinvestment risk. That's why you get the maximum benefit from a zero when rates fall. Likewise, when rates rise, you'd be better off with a coupon bond, since you'd be able to reinvest the coupon income at higher rates.

Second, in spite of their maximum interest-rate sensitivity, zero-coupon bonds are ideal for saving. That's because in exchange for forgoing coupon income, you buy them at a steep discount to face value. So, for example, instead of paying face value ($1,000 on most bonds) for a bond that will pay you $50 a year for 10 years and then give you the $1,000 back, you might pay $200 for a zero that will pay you $1,000 in 10 years, but no coupon income along the way. So if you're sure you need $1,000 (or, more likely, $100,000) in 10 years and not a moment sooner (because if rates have risen, you don't want to have to sell), and you can get that certainty for $200 instead of $1,000, what do you care about interest-rate sensitivity?

Third, the most common zero-coupon bonds and funds (

American Century

manages the widest array of zero-coupon funds) are Treasury obligations. This makes them relatively liquid. If you have to sell the bond, you're more likely to be offered a decent price for it, and the fund's price shouldn't ever suffer from liquidity problems in the market. But it also makes their yields relatively low. Bottom line: If you buy Treasury zeros, also known as STRIPS (the acronym stands for separate trading of interest and principal securities), or a fund that invests in them, you are forgoing the extra yield you'd get from a riskier corporate or municipal bond. There are corporate and municipal zeros, but they are relatively scarce, and there are no funds dedicated to them.

Finally, you may want to think twice about holding zeros or zero fund shares in a taxable account. Because while the bonds won't pay you any interest, you'll owe tax on them each year as though they did. With regular taxable bonds, you get taxed on the interest. With zeros, you get taxed on what's called the imputed interest, an amount based on the bond's yield. As for the funds, they'll at least pay you the imputed interest, so there's an income stream to cover the tax bill. But if you want a zero-coupon fund to deliver a total return comparable to that of a zero-coupon bond, you need to reinvest your dividends. (For a fuller explanation of how this works, please see a previous

Fund Forum on American Century's zero-coupon funds.)

The investment implications are pretty simple. Unless they're munis, zeros are most practically held in a tax-deferred account. In either case, they are an ideal vehicle for saving. They're what you want for the maximum benefit from falling interest rates. But if you can tolerate credit risk, you might want to diversify your bond holdings with investment-grade corporate or high-yield bonds.

Elizabeth Roy answers your bond fund questions each Friday. Dagen McDowell answers your general mutual fund questions Monday through Thursday. Send your questions to

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TSC Fund Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.