11 minute read
Chapter 10 Zero Investment
“Dig a well before you are thirsty.”
Do I Need to Read This Chapter?
Advertisement
• Do I need to save money toward a particular life event in the future,such as college tuition for my child? • Am I aware of zero coupon bonds? • Can I balance a predictable,long-term investment with a certain degree of risk?
• Am I interested in an investment with tax-deferred features?
Is there an instrument that lets you know exactly how much money you will have at a particular future date (whether it be for your child’s education, your retirement,etc.) and,if administered correctly,becomes tax deferred or even tax exempt?
As you will see in the following pages,zero coupon bonds have some definite advantages over other types of long-term investments.They have become a good choice for pension funds and for a child’s college savings.They are therefore an ideal investment for those of you who are more concerned about “outcome”than “income.”
How Does the Zero Coupon Bond Work?
Bonds are debt obligations issued by a corporation or by a federal,state,or local government agency.When you buy a bond (usually at face value),you are
buying a promise from the issuing institution to pay the amount of the face value of the bond at maturity.“Zeros”are sold at a price well below the face value.Thus,these bonds are appealing to the small investor because they can be bought for cheaper than ordinary debt obligations.The discount is usually from 50 to 75 percent.
For example,a zero with a face value of $1,000 (at 8 percent) may sell for just $456.You pay $456 today;at the time of maturity—10 years—you can redeem the bond for its full $1,000 face value.The extra $544 paid on redemption is the accumulated 10 years’ worth of interest on your $456 investment.
As the old saying goes, “Good things come to those who wait.” If waiting patiently isn’t your nature, zero coupon bonds are not a suitable investment for you. They are strictly for the long term. During the life of the zero, you clip no coupons and receive no interest payments (hence the term zero coupon). The entire interest payout comes at once—upon redemption.
Table10.1 shows the price for a $1,000 zero coupon bond under various interest rates and maturity dates.Naturally,the longer the term of the bond and the higher the interest rate,the greater the discount at which the bond is sold.Note that the amounts are rounded to the nearest dollar.
If you’re still in your twenties or thirties,you may purchase a big chunk of retirement money very cheaply by buying a long-term zero right now.
Table 10.1 The Cost of a $1,000 Zero Coupon Bond
Maturity Date and Cost* Interest Rate 5 Years 10 Years 15 Years 20 Years 25 Years 30 Years
6% $744 $544 $412 $307 $228 $170 7% 709 502 356 255 179 127 8% 676 456 308 208 141 95 9% 644 415 267 172 111 71 10% 614 377 231 142 87 54
* Actual price can vary because of availability, fees, and other factors affecting bond prices.
For example,at an 8 percent interest rate,you may buy a zero redeemable at $1,000 in 30 years for under $100.It’s hard to imagine a better buy than that.
What Advantages Do Zeros Offer as an Investment?
Zeros do offer several distinct advantages: 1.Call protection 2.Liquidity 3.Adaptability 4.Special suitability for tuition savings
Let’s look at each of these in depth.
1.Zeros have call protection,meaning that it is unlikely that they will be called in for early redemption by the issuing company if interest rates should fall. (There’d be no advantage to the corporation in prepaying the interest on zeros unless there were special call provisions in the agreement.)
Remember to be certain to find out whether the bond you wish to purchase is callable,and if so,ask about its “yield to call.” Yield to call means that you will be guaranteed a set return if the bond is called in early.Also,if interest rates in the market should fall,with a conventional bond the interest payments you receive would have to be reinvested at a lower existing rate.You avoid this when you purchase zero coupon bonds because the interest is reinvested at the fixed rate (which was higher than the prevailing rate) at which you purchased them. 2.Zeros also offer liquidity.If,for some reason,you need to sell your bond before maturity,you can sell it on the so-called secondary market at the current rate.This may produce a gain or loss,depending upon interest rates at the time of the sale.For example,if interest rates are higher at the time you dispose of the bonds,you will take a loss.However,a lower interest rate will yield you a profit.And speaking about interest rates,another advantage of zeros is that you avoid the roller-coaster ups and downs of interest rates if a bond is kept to maturity.As stated above,the value of a bond will rise if interest rates fall and will drop if interest rates rise.With zero bonds,
no matter how much their value may fluctuate and fall,at maturity the bond will be redeemed at its face value.This gives you the assurance of knowing exactly what you will receive at a certain time in the future. 3.Most important,zeros adapt themselves very well to a variety of personal financial plans.Because you know exactly how much money you’ll be receiving for your investment and exactly when the payout will occur,you can make long-range plans on the basis of your investment in zeros.Thus, they may become an alternative choice,in some cases,for your individual retirement account. 4.Zero coupon bonds are also an excellent way of saving for your child’s college tuition.That just-born baby is certainly a joy today but financially a major cost problem years from now.(Someone has described a baby as making your days shorter,nights longer,bankrolls smaller,the past forgotten,and the future worth living for.) So true.You can invest in zeros that will mature at the time your child is ready for school and,at the same time, greatly reduce the tax bite on the interest if the transaction is done properly.
Assume that under the Tax Reform Act only the first $1,700 of your child’s unearned income will be taxed at his or her low rate,with the first $850 being exempt (because of the standard deduction).This means that by reporting the interest each year on the child’s return,you will get that exemption 18 times (assuming an 18-year bond),for a total of $15,300.
However,if the interest were to be reported in one lump sum only (as with some instruments),you would be able to use the $850 exemption only once.
Also,by declaring the tax each year,you do not have to concern yourself about having a taxable lump-sum amount come due just when you are about to pay for your child’s college tuition.(For more about taxes,see the following section on disadvantages.)
What Are the Disadvantages of the Zero Coupon Bond?
As a wise person once said,“Perfection is not of this earth.”This is another way of saying that zero coupon bonds,good as they are,do have their disadvantages. The degree of risk is one.If the company issuing the bonds is no longer solvent at the time of maturity,you may lose your entire investment.The possibility of default is a serious consideration with bonds of every kind,but the
problem is especially significant with zeros.This is because you receive all interest payments at one time,upon maturity,whereas with other types of bonds you receive interest on a regular basis throughout the life of the bond.
A second disadvantage involves the markup that brokers add to the wholesale price of the bonds.The cost to purchase a zero is much higher (in percentage terms) than that of ordinary bonds because of the broker’s markup,which is based on face value rather than cost.For example,a $30 commission on an ordinary $1,000 (face value) bond is 3 percent,but on the much smaller price of a zero it would be higher.It is very difficult for an investor to determine what the markup is on zero coupon bonds because the bonds are not sold “net.”Brokerage houses buy them at wholesale and resell them to the general public at retail prices.The markup,which is used instead of a sales commission, will increase the price of buying the zero and will reduce the price you get when you resell.
The only way to know whether your broker is charging you a fair price is to shop around.Call other brokerage houses to see what the competition has to offer.Remember that the larger the broker’s markup,the more the bond will cost,leaving you with a smaller yield.Also,prices of zeros change every day,so if you are seeking the best rate,do all your shopping on the same day in order to compare fairly.
You can minimize the markup disadvantage by comparing what brokers have to say. The way to do that is by asking each of them the following questions: 1.How much will I have to invest in order to get the bond (zero) that I want? 2.How much will that investment be worth at maturity? 3.What is the effective yield to maturity?
The broker who can give the lowest figure for question 1 and the highest figures for questions 2 and 3 will be getting you your money’s worth.
As a humorous sidelight,those investors who were hurt in the 2001 market crash felt that people selling stocks are called brokers because after you take their advice,you are.
A third disadvantage involves taxes.Although you receive no cash payments during the life of the zero coupon bond,you are taxed as if you do,because
interest on a zero coupon bond must be reported to the IRS each year. After 18 years,a zero bought for $2,000 might grow to $10,000 at maturity. To report the $8,000 interest,you do not take 1⁄18 of the $8,000 ($444 each year),but instead the interest as it actually accrues.During the first year,a $2,000 investment earning 8 percent would produce approximately $160 in interest.In the second year,your investment would not be $2,000 but $2,160 ($2,000 + $160),and $172.80 would be the interest that year.You do not have to personally compute this every year;you will receive a notice from the issuer or your broker informing you of the amount of interest to report to the IRS.The tax on this “invisible interest,”also known as phantom income, can be considered a major drawback of zero coupon bonds,because you are forced to pay tax on income you haven’t received and will not receive for many years.To avoid this problem,look into zero coupon municipal bonds,which are tax free.
Another area of taxes involving zeros is the tax basis of these bonds increasing as interest accrues.If you wait until they mature,there is no problem.But if you sell before the due date,your basis determines capital gain or loss.Many investors fail to add accrued interest to their original investment,thus forcing them to pay higher taxes.This rule applies to corporate zero,strips,and taxfree municipal zeros.Your broker can give you the amount of accrued interest annually so that you can add it to your basic cost.
What Are Zero Coupon Municipal Bonds?
The zero coupon municipal bond performs the same way that a corporate zero coupon bond does except that it is issued by a state or local government agency.Because it is a municipal bond,the interest you earn is exempt from all federal taxes and,in many cases,if the bond is issued within your state,from state and local taxes as well.The amount you receive at maturity is considered tax-free income that has accrued annually from the time of the issuance of the bonds.
You should realize that all bonds have an interest-sensitive basis.That means that when interest rates rise,bond values fall;and when interest rates fall,bond values rise.This can occur because of the lack of regular interest payments.For example,if interest rates should rise,the holder of zeros would
not be able to reinvest the interest at the new higher rate.However,if interest rates should take a downward turn,earnings on the zero would continue to be reinvested at the older,higher rate.
Which Type of Zero Is Best for You?
If you’re sold on zeros,don’t rush out and buy the first one you find.Make your purchasing decision based on the taxable-equivalent yields paid by each type.(Taxable equivalent means the amount you have left after all taxes are paid.)
If quality is your primary criterion,the safety of Treasury zeros should be your choice,as there is no risk in a government obligation.If taxes are the prime concern because of your high tax bracket,look at municipal zeros.Although corporate zeros usually pay the highest yield,the market choice is small and the risk may be high.
You should consider the purchase of zero coupon bonds over a fixed rate when you need to have a predetermined amount of money on a certain date and you will not need to touch the instrument before maturity.Zero coupons will also be advantageous to the investor who does not wish to make decisions about reinvesting interest payments twice a year.It is said that you can just let the zero run on automatic pilot and thus avoid the semiannual decision on reinvestment that you would have to make with an interest-bearing bond.Tell your broker when you’d like your bonds to mature,and he or she can let you know when zeros that meet your future needs are available.
And on the topic of the future,today is the tomorrow that yesterday you spent money like there was none.
It’s a Wrap
• Zero coupon bonds are extremely well suited to long-term savings,such as tuition needs. • Zeros are appealing to the small investor because they can be bought far more cheaply than traditional types of bonds. • Zeros offer the advantages of call protection,liquidity,and adaptability to a variety of personal financial plans.
• The disadvantages of zeros are high initial markup,risk of default by the issuer,and tax complications. • For those seeking tax-deferred or tax-free investments,zero coupon municipal bonds should be considered.
