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Chapter 7 Zero-coupon bonds.

WHAT IS IT?

Zero-coupon bonds are sold at a deep "original" issue discount (see Chapter 43) from their face value. Investors receive the face value at maturity rather than periodic interest payments. Corporations and governmental entities issue zero-coupon bonds. Some zero-coupon bonds issued by state and municipal governments are tax-exempt. For example, a zero-coupon bond issued at $500 and maturing in 10 years at $1,000 provides a yield of 7.18%.

WHEN IS THE USE OF THIS TOOL INDICATED?

1. With zero-coupon bonds, investors know their exact yield to maturity since they do not have to worry about reinvesting cash flows at, perhaps, lower rates of interest than they are receiving on the bond. If the bond is held to maturity and does not default, the return is guaranteed. Consequently, zero-coupon bonds are especially appropriate when investors wish to "lock in" a rate of return and be assured of a specified accumulation at a given future date (i.e., the maturity date).

2. Taxable zeros are very attractive conservative investments for retirement plans. The tax shelter feature of the retirement plan allows the unpaid, but otherwise taxable accruing interest to be tax deferred.

3. Tax-exempt zeros are suitable conservative investments for high-tax-bracket investors who wish to accumulate wealth, have little need for current cash flow, and who do not desire to worry about reinvestment of cash flows.

4. Zero-coupon securities are frequently used to meet specific financial or investment goals, especially when the date of a future need is known well in advance. (1)

ADVANTAGES AND DISADVANTAGES

1. Although investors are assured that they will receive a reinvestment rate equal to the yield to maturity if they hold the bond to maturity, they derive this certainty by foregoing the opportunity to reinvest at higher rates if market interest rates rise.

2. Prices of zero-coupon bonds are much more sensitive to changes in interest rates than coupon bonds of comparable term and quality. Consequently, if an investor has to sell a zero-coupon bond before maturity, there is no assurance that he will realize the anticipated yield.

3. Many zero-coupon bonds are callable at the discretion of the issuer. If a zero-coupon bond is called before maturity--which is more likely to occur when interest rates have fallen--the investor will generally not be able to reinvest the proceeds at the yield to maturity he enjoyed on the zero-coupon bond.

TAX IMPLICATIONS

The investor must generally include accruing interest in his taxable income (unless it is a tax-exempt issue) even though no cash is received until the bond matures, is sold, or is called.

ALTERNATIVES

Deep-discount, low-coupon (market discount) bonds. Investors may acquire low-coupon bonds at substantial discounts from their face values, depending on the coupon rate and the remaining time to maturity. Investors are assured that the portion of the interest that is cash deferred until the bond matures will be effectively reinvested at the original yield to maturity, similar to zero-coupon bonds. (See Chapter 3 for an explanation of the tax treatment of market discount bonds.)

QUESTIONS AND ANSWERS

Question--What are LYONs (Liquid Yield Option Notes)?

Answer--LYONs are zero-coupon convertible notes. Corporations issue zero-coupon bonds that are convertible into a fixed number of shares of common stock of the issuer. Investors who choose to convert forfeit all accrued interest on the bonds.

These bonds are generally less valuable as convertibles than as zero-coupon bonds because it becomes more expensive to convert as time passes (because the investor must forego accrued interest).

Question--What are "bunny bonds" or multiplier bonds?

Answer--A "bunny bond" or multiplier bond is a bond in which investors reinvest the income into bonds with the same terms and conditions as on the original bond (thus, the term "bunny" bond because they multiply like bunnies). This reinvestment feature makes bunny bonds very similar to zero-coupon bonds.

These bonds eliminate the reinvestment problem characteristic of all income-producing assets--namely, the uncertainty of the rate of return at which the income can be reinvested. These bonds are especially well suited for retirement funds and other tax-sheltered vehicles or for tax-exempt entities, since investors must include interest in taxable income even though they receive no cash until the bonds mature.

The principal risk is that interest rates will rise and the investor will be "locked" into reinvesting at the lower specified rate. Because of the automatic reinvestment feature, the price of these bonds is more sensitive to interest rate changes than the price of a conventional bond of similar quality and maturity. The price will tend to fall more than conventional bonds of comparable quality and maturity when interest rates rise. On the other hand, if interest rates fall, the investor reinvests at the higher rate and the price of the bond will rise more than conventional bonds of similar quality and term to maturity.

Bunny bonds can be compared to bonds issued with detachable or nondetachable warrants. A warrant is like a long-term call option (see Chapter 41) that allows the investor to acquire more bonds of the same issue or a new issue at a specified price and yield.

CHAPTER ENDNOTES

(1.) Before 2006, an investor seeking to provide college education funds in 10 years might have selected an issue with a similar maturity date. Such an investor might have considered whether purchasing the bonds under the "Uniform Gifts to Minors Act" (UGMA) would shift income taxation to the child's relatively lower bracket. However, under the Tax Increase Prevention and Reconciliation Act of 2006--TIPRA), the "kiddie tax" age was raised from 14 to 18; consequently, this tax favored strategy has effectively been nullified. IRC Sec. 1(g)(2)(A), as amended by TIPRA 2005.
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Title Annotation:Tools of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
Date:Jan 1, 2006
Words:942
Previous Article:Chapter 6 Stripped bonds.
Next Article:Chapter 8 Promissory notes.
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