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    Diversify your portfolio with zero coupon bonds

    Tool provides investor exposure to bonds when no current income is needed

    Joel M. Blau, CFPJoel M. Blau, CFP Ronald J. Paprocki, JD, CFP, CHBCRonald J. Paprocki, JD, CFP, CHBC

     

    I want to use bonds in my portfolio to diversify away from equities as I approach retirement, but I don’t need any current income. Are there bonds that don’t generate annual income?

    The baby boomer generation, in particular, appears to be well-focused on attaining and maintaining a comfortable retirement standard of living but remains concerned about the fluctuations in the equity markets, in which they are heavily invested. As a complement to their portfolios, many boomers are increasing their bond holdings in an effort to add diversification and reduce their overall risk exposure. Caution needs to be exercised, however, as many investors are under the misunderstanding that bonds cannot lose principal value.

    Related: Tying the knot raises multiple financial issues

    From the moment a bond is purchased, it is subject to market fluctuation. A prime cause of the fluctuation is often attributable to overall changes in interest rates. As a general rule, bonds move inversely with interest rates. If interest rates go higher, bond prices decrease, and conversely, they go up in value as interest rates decrease.

    Other bond investment risks include “credit risk,” which rating agencies define as the ability of the issuer to pay back interest as well as principal. Beyond credit and market risk, there is also the risk that the issuer will “call” the bond prior to maturity at a pre-stated value.

    If there is no current income needed from the bond portfolio, but you still want that exposure to bonds, you may want to consider utilizing a portfolio of zero coupon bonds. Zero coupon bonds are debt instruments issued at a discount to their face value, make no interest payments, and pay face value at time of maturity.

    For example, let’s look at a hypothetical zero coupon bond issued today at a discount price of $743 with a face value of $1,000, payable in 15 years. If you buy this bond, hold it for the entire term, and receive the face-value payment, the difference of $257 represents the interest you earned. In this hypothetical example, the bond's interest rate would amount to approximately 2%.

    Next: "Zero coupon bonds are predominantly issued by the federal government and typically have maturities of 10 to 15 years"

    Joel M. Blau, CFP
    Mr. Blau is chief executive officer of MEDIQUS Asset Advisors, Inc., in Chicago. He can be reached at 800-883-8555 or [email protected]
    Ronald J. Paprocki, JD, CFP, CHBC
    Mr. Paprocki is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago.

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