Think that zero-coupon certificates of deposit mean zero risk?
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Zero-coupon CDs are bought at a deep discount, with interest accreting annually. At maturity, the CD pays out at a higher face value. For example, a $75,000 zero-coupon CD may be bought for, say, $50,000, and matures in seven years. Interest is not paid annually, but it is still treated as taxable income every year.
But here's where the risk comes in. These CDs lock in your money at lower rates, especially when interest rates look like they'll rise and interest is paid out years later.
Why? Because maturities can range from three to 30 years.
"Drawbacks loom large, especially when investors are reaching for higher yields," says Greg McBride, CFA, a senior financial analyst at Bankrate.com. "And interest rate risks are acute in the next few years."
Drawbacks to Zero-Coupon CDs
Here are some additional downsides worth considering:
Income is taxed yearly. Even though you don't receive any interest until the CD matures, you must pay taxes on it each year. And if you opt for a hefty $100,000 CD, your tax hit can be big.
"Basically, you're paying out of your own pocket for this phantom income unless the CD is in a tax-advantaged retirement account," McBride says.
Zero-coupon CDs may be callable. That means that your zero-coupon CD can be whisked away from you before it matures. This is usually true during times of falling interest rates, McBride says.
They provide no steady income. Retirees who need a yearly cash flow should look elsewhere.
"Ultimately, the CDs are aimed at extremely conservative investors with no cash flow needs," says Brad Levin, president of the wealth planning firm Legacy Wealth Partners in Woodland Hills, Calif.
Zero-coupon CDs are usually brokered. Good luck finding zero-coupon CDs at a bank, Levin says. They're usually sold through a brokerage firm, which means you may pay extra fees. And be prepared to hang on for long maturities -- as much as 15 to 20 years. Recently, Wells Fargo and Prudential have sold these brokered CDs.
These CDs aren't as liquid as you may think. Withdrawing money before a zero-coupon CD matures is no easy matter. You must sell it on a secondary market, where prices are driven by investor demand. That means you may lose money on your investment as CD values fluctuate.
Also, if interest rates rise, you're stuck with a lower-yielding CD when other investment vehicles are yielding more. That's why going with short-term, more liquid CDs is preferable to investing in longer-term CDs, McBride says.
Plus Sides of Zero-Coupon CDs
Make no mistake, there are upsides, too. Zero-coupon CDs may pay higher yields than traditional CDs. For example, a two-year zero-coupon CD might yield 2.4% compared to a traditional CD paying 1.5%, Levin says.
And you also know what rate you're getting because the CD matures at a stated face value. Each year, that value grows as interest is added until the CD reaches maturity. Another plus is that buying the CD at a substantial discount gives you bigger bang for your buck at maturity, Levin says.
McBride says zero-coupon CDs are best suited to investors who are saving for long-term, targeted goals such as buying a house.
Investors who don't have hefty deposits should look at laddering traditional CDs instead, where you buy several different securities with different maturities, McBride says. You can buy them with modest deposits.