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Risks in new agency structure.

Federal agencies such as the Federal Home Loan Bank System and the Federal Home Mortgage Corporation (Freddie Mac) began issuing zero-coupon bonds in June 1997. Some dealers have been marketing the new Freddie Mac zero-coupon bonds to institutional investors. This article highlights potential problems for investors.

The new agency bonds typically have a maturity of 10 years or more and a call option of five years or less. Some of these bonds are callable at six-month intervals after an initial lockout period. During the summer of 1997 some of the bonds were sold through regional dealers at a discount to yield 8 percent to maturity. This attractive yield was used to lure retail investors, as a comparable yield for an agency bond paying a cash coupon with the same maturity and call structure would have been closer to 7 percent.

A yield of 8 percent may sound attractive on the surface; however, it may not be enough yield to compensate investors for the risk added by the call option. Investors purchase these bonds because they focus on the 8 percent yield to maturity and not on the negative value of the call.

When contemplating the purchase of a callable bond, investors should calculate the yield to call of the bond, which is the yield an investor would receive if the bond is called by the issuer prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to call, and the market price of the bond. Yield to call can be significantly lower than yield to maturity, which is the return a bondholder can expect to receive if the bond is held until maturity.

Investors should evaluate the yield to call under different interest rate scenarios and compare those assumptions against other investment options. Callable bonds may appear unlikely to be called at current interest rate levels. Shifting the yield curve downward by a minor amount, however, may greatly increase the likelihood that a bond will be called well before scheduled maturity.

Falling interest rates provide issuers with the impetus to call their bonds early, forcing bondholders to reinvest principal at a lower yield. This is known as reinvestment risk. While yield to call can look attractive under certain circumstances, buyers should take into consideration the lower reinvestment rates that will be offered for subsequent investments and should calculate an overall horizon return. Public investors must remember that they are not in the business to make market bets on the direction of interest rates 5-10 years into the future.

More about zeroes. Zero-coupon bonds are sold at a discount from face value and accrete to par value (return to full face value) at maturity. The "interest" is the difference between the purchase price and the maturity price. Retail investors commonly use zero-coupon bonds for financial planning purposes. These bonds are attractive to retail investors because they have a predictable rate of return and eliminate the need to reinvest coupon payments.

Zero-coupon bonds are more volatile than coupon bonds, all else being equal, due to their lack of coupon cashflows to offset changes in market price. A change in interest rates affects the market price of zero-coupon bonds more dramatically than that of coupon bonds. If interest rates fall, noncallable zeroes experience additional price appreciation compared to noncallable coupon bonds.

Callable zeroes, however, will not experience the same price appreciation as noncallable zeroes due to the negative price impact of the call option. The value of the call option to the issuer increases as interest rates fall and exercising the call becomes more potentially lucrative. To the investor, on the other hand, the increasing value of the call option is a negative factor as it limits potential price appreciation. In addition, when interest rates rise, zeroes will experience greater price depreciation than coupon bonds. The lower market value will have to be recorded in compliance with the Governmental Accounting Standards Board (GASB) recently released Statement No. 31, Accounting and Financial Reporting for Certain Investments and for External Investment Pools. GASB 31 requires that governments holding debt securities with maturities over one year in their portfolios value these securities at fair market value rather than amortized cost.

Another important consideration is that these bonds may be difficult to price fairly. Some dealers have been known to mark up prices on zero-coupon securities. As with any purchase of securities, investors should obtain several competitive quotes before purchasing this type of security from dealers and should compare its yield to alternative investments with comparable characteristics. Furthermore, potential purchasers should be confident that they are being adequately compensated in the form of additional yield for all investment risks. Callables should have a higher yield than non-callables and zeroes should have a higher yield than coupon bonds, all else being equal. Because the callability of the new agency zeroes negates the usual motive for holding zeroes - to profit from falling interest rates - investors should require a significant yield premium, keeping in mind, however, that interest rates are low now.

Finally, the long maturity and volatility of these new agency issues makes them unsuitable for inclusion in a short-term operating cash portfolio. Zero-coupon bonds are a long-term investment and must be evaluated as such. The risks of long-term investments are market risk (the risk that changes in interest rates will reduce the value of the security), reinvestment risk (the risk that the investor will have to reinvest funds at a lower rate), and illiquidity risk (the risk that the security cannot be sold prior to maturity without incurring a significant loss).

M. CORINNE LARSON, assistant director in GFOA's Research Center, prepared this article. Contributors were Stanley Shavers, vice president, fixed income, ICMA Retirement Corporation; Melanie El-Sabaawi, senior investment analyst, ICMA Retirement Corporation; and Linda Patterson, president, Patterson and Associates.
COPYRIGHT 1997 Government Finance Officers Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997 Gale, Cengage Learning. All rights reserved.

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Author:Larson, Corinne
Publication:Government Finance Review
Date:Dec 1, 1997
Words:970
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