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Zero
Coupons and STRIPS
http://www.bondsonline.com/zeros.html
Creating Zeros by Coupon Stripping
The body of the stripped securities and the separate coupons are known as "zero coupons" or "zeros" because there are no periodic interest payments on each instrument. After stripping, the body and coupons are sold at a deep discount from their face values. An owner benefits only from the difference between the purchase price and the payment received upon sale or at maturity. For example, a 20 year bond with a face value of $20,000 and a 10% interest rate could be stripped into its principal and its 40-semi-annual interest payments. The result would be 41 separate zero coupon instruments, each with its own maturity date. The principal would be worth $20,000 upon maturity, and each interest coupon $1,000, or one-half the annual interest of 10% on $20,000. Each of the 41 securities, now possessing a distinct ID number, could be traded separately until its maturity date at prices determined by the market. Proliferation of Treasury STRIPS Some Treasury securities were traded in the secondary market without one or more of their interest coupons in the late 1970s. Stripped securities offered investors a financial instrument that had abundant supply, no default risk, and low incidence of being "called," or paid off, before their maturity date. However, their popularity raised fears within the Treasury Department that zeros would result in a sizable loss of tax revenues. Detached coupons and the body of the security were sold at deep discounts, $.05 or $.10 on the dollar. After purchase, an investor claimed a capital loss on the difference between the sale price of the security and its face value, thus reducing the investor's overall tax liability. The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 adjusted the tax treatment of stripped securities to reduce their tax advantage. The Treasury Department then withdrew its objections to coupon stripping, prompting several securities dealers to create new products incorporating receipts for stripped debt securities. TEFRA also required the Treasury to begin issuing all of its securities in book-entry (electronic) form only, beginning on January 1, 1983. This provision eliminated Treasury issues of bearer notes and bonds with coupons attached. Physical stripping would no longer be possible. In response, bond dealers began to market receipts that evidenced ownership of Treasury zeros held by a custodian. The first of these "receipt products" were named Treasury Investment Growth Receipts, or TIGRS. Similar products appeared in 1984, such as Certificates of Accrual on Treasury Securities (CATS) and Treasury Receipts (TRs). However, most of these securities were not exchangeable with other stripped securities, and thus lacked the liquidity customers had come to expect from "zero" instruments. In February 1985, the Treasury took a more active role by introducing its own coupon stripping program called STRIPS, an acronym for Separate Trading of Registered Interest and Principal of Securities. The STRIPS program was intended primarily to reduce the cost of financing the public debt "by facilitating competitive private market initiatives." Under the STRIPS program, U.S. government issues with maturities of ten years or more became eligible for transfer over Fedwire. The process involves wiring Treasury notes and bonds to the Federal Reserve Bank of New York and receiving separated components in return. This practice also reduced the legal and insurance costs customarily associated with the process of stripping a security. In May 1987, the Treasury began to allow the reconstitution of stripped securities. Part of a Balanced Portfolio Stripped securities can be purchased only from private dealers and brokers. Although the Federal Reserve provides services to the zero coupon market, it does not actually sell these securities for the Treasury. Financial services companies decide when and what portion of an eligible security are stripped and sold. Because their increase in value is taxable yearly as it accrues, zeros have become most popular for investments on which taxes can be deferred, such as individual retirement accounts and pension plans, or for nontaxable accounts. However, their known cash value at specific future dates enables savers and investors to tailor their use to a wide range of portfolio objectives. Source: Federal Reserve Bank of New York ============================================================ Zero-Coupon BondsZero-Coupon Bonds are purchased at a discount (a price below $1,000 per bond) and grow to $1,000 on the maturity date. U.S. Treasury zero-coupon bonds are backed by the U.S. Government. Municipalities and corporations also issue zero-coupon bonds with their respective characteristics. They are called zero-coupon bonds because they do not pay periodic interest. Similar to treasury bills, the increase in value is reflected on an annualized yield basis. This "deferred" interest may be taxable each year. Please consult your tax advisor for details. Many investors view these as ideal investments for tax-advantaged accounts, such as IRA’s, Keoghs and pension plans. These bonds are also suitable for college education savings plans as they will deliver a set dollar amount on a given date. Zero-coupon bonds, by their nature, are more volatile than regular bonds. As an example, a 30-year zero-coupon treasury will exhibit about two-and-a-half times the volatility of a regular treasury bond. Hence, they will likely show greater appreciation during times of declining interest rates and their market value will fall at a greater rate than regular bonds during a period of rising interest rates. For investors intending to hold zero-coupon bonds until maturity, their volatility becomes less of an issue. However, investors who may need to sell the bonds before maturity should take into account their volatility when they design the fixed-income portion of their portfolio. ©1997 OLDE Discount Corporation. All
rights reserved. Making the Most of Zeros Zeros are simple, but their tax treatment isn't. A zero-coupon security -- known as a "zero" -- is frequently recommended for certain types of investors, especially if the investor wants to lock in a particular interest rate for a specified time period. A prospective investor must understand not only the investment consequences of zeros, including their interest rate and credit risks, but also their relatively complex income tax treatment. Definition Zeros (as discussed in this article) are debt securities that are issued at substantial discounts from face value, offer no periodic interest payments, and pay the principal amount or face value at maturity. They may be obligations of the U.S. Treasury, governmental agencies, municipalities, or corporations.
For feedback or suggestions contact the [email protected]. Acceptable Issuers of Letters of Credit and Banker’s Acceptances Maximum Value of LOC’s/ BA’s Acceptable to CDCC Domestic Banks http://www.cdcc.ca/english/enotice.htmPutting Compound Interest to Work Through Zero Coupon Bonds. http://www.investinginbonds.com/In chemistry, a compound substance refers to a combination of two or more elements that cannot be separated. In math, a compound fraction means a fraction that has a numerator, a denominator, or both that contain fractions. In finance, compound interest means you're likely to achieve your financial goals sooner. The earlier you begin a regular investment program, the earlier compounding interest can go to work for you. As with most fixed-income securities, zero coupon bonds offer investors a high degree of safety when held to maturity and the opportunity to earn compound interest over the life of the bond. In addition, if you purchase a zero coupon bond issued by a state or local government entity, the interest compounds free of federal taxes, and in most cases, state and local taxes, too. With conventional bonds, the investor pays the face amount of the bond and receives interest payments every six months based on the coupon, or interest rate, offered when the bond is sold. When the bond matures, the investor then is reimbursed the full principal amount invested. When purchasing a conventional bond, you invest an amount equal to the face value of the security. As long as you own the bond, you receive regular interest payments and recoup the initial investment when the bond matures. A zero coupon bond, on the other hand, is sold at a discount from its face value and the issuer makes no interest payments during the life of the security. When it matures, you receive the full face amount which equals your initial investment plus accumulated interest compounded over the life of the bond. (The examples cited refer to issues sold in primary market offerings.) For example, an investor could purchase a 20-year municipal zero coupon bond with a face amount of $20,000 for approximately $6,757. When the bond matures, the investor receives the full, face amount, $20,000. The $13,243 difference is attributable to the accumulated compounded interest, in this case calculated on the basis of a 5.5% rate of return. Because the bonds are sold at a discount to their face value, the investor also benefits from having a lower upfront amount to invest, an advantage for those who are just starting out or have more modest amounts to invest. Zero coupon bonds were introduced to the fixed-income market in mid-1982. Today, the three largest categories of zero coupon securities are offered by the U.S. Treasury, corporations, and state and local government entities. As with all bond issues, zero coupons issued by the Treasury are generally considered the safest because they are backed by the full faith and credit of the U.S. government. Municipal zeros also offer a high degree of safety, and, because the interest earned is usually tax-free, can generate higher returns when calculated on a taxable equivalent basis. For example, an investor filing a joint return in the 28% tax bracket would have to purchase a zero coupon bond at 7.97% to equal the tax-exempt municipal yield of 5.5%. The savings add up further if the municipal zero coupon bond is issued by an entity in the investor's own state. Corporate zeros offer a potentially higher degree of risk, depending on the financial strength of the issuing corporation, but they also offer the opportunity to achieve a higher return. A zero coupon bond issued by a corporation or the U.S. Treasury is also taxable, unlike those offered by a municipal issuer. Even though you do not receive your interest payments in cash while you hold the bonds, you must pay income taxes each year on the interest as if you had. For that reason, you may want to purchase a taxable zero coupon bond for your Individual Retirement Account (IRA) or other tax-sheltered retirement account, such as a 401(k) plan. Zero coupon bonds enable investors to tailor their purchases according to their own time horizons. For instance, there are zeros with maturities ranging from one to 40 years, with the majority between 8 and 20 years. So, if you're investing for a specific objective, such as retirement, or the start of college tuition, zero coupon bonds provide you with the ability to time the maturities to when you need the money. There are also different types and grades of bonds and, as with all bonds, credit quality is a factor. Most corporate and municipal zero coupon bonds are rated by the major rating agencies, Moody's Investors Service, Standard & Poor's, Fitch IBCA, and Duff & Phelps. The benefits of compound interest, which zero coupon bonds provide, may be the way you can get started toward meeting your financial goals. 40 Broad Street, New York, NY 10004-2373
Bull & Bear - Vol 9, No. 12 (June 1989) http://www.2020tech.com/pcalby/bb01.html Multiply your investment with tax deferred zero coupon corporate bondsBy Pat Calby Many investors are looking for an investment for outside of a retirement account that is highly liquid, say as liquid as gold bullion, and very safe yet, if held for the long term, will multiply their investment dollars with little downside risk. The investor is seeking a safe, reliable vehicle that will provide a predictable and attractive rate of return. Tax Deferred Zero Coupon Bonds are attractive investments for this type of person. Zeros provide the following: when you purchase a Zero Coupon Bond you will know at the time of investment exactly how much your investment will grow to in a certain period of time. Investors lock in a true compound interest rate for the entire period of the investment. The difference between your purchase price of the zero and the face value of the bond, which is the value at maturity, is your total return. You don't have to fear reinvesting coupon payments at lower interest rates because you lock in your rate when you make the investment. During a six month period in 1982, there was a short lived loophole in U.S. tax law which created Deferred Interest Corporate Zero Coupon Bonds. Deferred Interest Bonds were issued in 1982 and the bonds were used in exchange offers for other outstanding debt issues. They are different than the usual Zero Coupon Bonds as the tax on interest during the life of the bonds is deferred until sale or until the bonds mature. Two companies were the main issuers of these bonds. GMAC and Exxon Shipping. GMAC is the world's biggest finance company doing both retail and wholesale financing for all of General Motors Products and Services. Exxon Shipping debentures are guaranteed by Exxon Corporation, one of the world's largest oil companies. A general description of these bonds is below. The GMAC bonds are listed on the New York Stock Exchange Bond Board. The Exxon Shipping do not trade on a centralized exchange. The bonds are recommended for outside of a retirement plan because they are tax deferred. No federal income tax is due on them until they mature or you sell, whichever comes first. Inside an IRA, Keogh, SEP or other retirement plan, you are better with Treasury's. When Zero's are purchased in a child's account, UTMA/UGMA, the child's tax rules apply. The first $500 of a child's income is not taxed, the next $500 is taxed at the child's tax rate (currently 15%) and any investment income above $1000 is taxed to the child at the parent's tax rate. The only exception to this is for children age 14 or older. Their investment income above $1000 is taxed at their own rate. These bonds are great for the account of a young child who pays tax at the parent's rates now, but whose tax bracket will drop upon reaching age 14. The bonds can be bought now and sold in time for college. Zero Coupon Bonds, like all other fixed income securities, are subject to market risk. There is an active secondary market for them and the future value of Zero's, if held to maturity, will not change. They are more susceptible to interest rate changes than other coupon type vehicles. When interest rates fall, the value of Zero Coupons tend to rise more than coupon issues, but when rates rise, the value of Zeros tend to fall more than the value of coupon issues. The long the maturity, the greater the fluctuations. So, if you sell a Zero Coupon prior to maturity, you could have a profit or a loss, depending on interest rate trends. By investing in these bonds, it is possible for an investor to lock himself in a % return for over the next 20 years. There isn't many investment vehicles out there that have averaged this type of return over this long period of time. How many stocks or mutual funds have actually achieved this type of return over this length of time. If interest rates drop from where they are right now, an investor in these bonds could have a very nice capital gain.
* Price April 19, 1989 UPDATE: December 1, 1994: The Exxon Shipping Bonds indenture changed and name changed to Sea River Maritime Financial Holdings, everything else including the AAA/Aaa rating by Standard & Poor's Corporation and Moody's Investors' Services continue to be the same. May 17, 1999 Updated Bond Prices Sea River 2012 (formerly Exxon Shipping) $450.00 yield 6.1% GMAC 2012 $385.25 GMAC 2015 $318.875
[ Also see Vol 9, No. 11 (Feb/March 1989) issue of The Bull & Bear Financial Newspaper. ]
Reprinted with permission from The Bull & Bear Financial Newspaper, P.O. Box 4267, Winter Park, FL 32793. Buy zeros now http://www.forbes.com/forbes/99/0222/6304146a.htm By A. Gary Shilling QUICK, which has been the hottest investment since 1982, stocks or Treasury bonds? Surprisingly, the Treasurys have done better, if you bought them in the form of long-maturity zero coupon bonds. Few investors, I would wager, have any good idea how huge the profits from bonds can be when interest rates are falling. But it's not too late to learn this lesson and put it into practice. If my forecast of deflation and falling interest rates is correct, then you have another chance to beat stocks by owning zero coupon Treasury bonds over the next few years. To understand the strategy, remember what happened in the 1980s. With soaring inflation, long-term Treasury yields jumped to a peak of 14.7% in September 1981. At that point, investors finally came to expect lower inflation, so they started buying bonds. That pushed yields down (and touched off the bull market in stocks). Now consider the power of falling interest rates. If rates were to fall, say, one percentage point from current levels, today's 10-year Treasury bond would gain 8% in price. A 20-year bond would gain 12%; a 30-year bond, 17%. A 25-year zero coupon bond, which sells at a discount because it pays interest only when it matures at par, would gain 28%.
If you had bought a 25-year, zero coupon Treasury when rates peaked in 1981, you would have gained an astounding 75% by mid-1982 when stock prices bottomed. But let's assume that your forecasting wasn't perfect and you instead waited to buy zeros until stocks started moving up. If you held each zero until the end of the year, then cashed it in and rolled the proceeds into another bond to maintain a steady, 25-year maturity, you would have gained an average of 24% per year by the end of 1998. Those return figures are based on data from Bianco Research in Barrington, Ill. In contrast, the S&P 500, with dividends reinvested, gained 20% per year over that period. Of course, long-term zero coupon bonds carry a lot of interest-rate risk; they're volatile both up and down. Twenty-five-year zeros crashed by 22% in 1994's interest rate spike. Indeed, the annual standard deviation of that constant-maturity zero portfolio since mid-1982 has been a sky-high 35%, nearly triple the standard deviation of the S&P. My return figures assume that assets are held in a tax-deferred account such as an IRA. Returns on frequently traded zeros are much lower in taxable portfolios for two reasons: Appreciation in lieu of interest payments is taxed annually, even if the bonds aren't sold, and so is any gain caused by falling interest rates when the bonds are rolled over to maintain long maturities. Zeros work far better in tax-free accounts, and I have used them for years in clients' IRAs and pension portfolios. (You will have to pay trading costs no matter what, of course.) That's all history. What lies ahead? As regular readers of this column know, I firmly believe we're headed for a time of benign price deflation, propelled by increasing productivity and the resulting excess supply. The engine of this productivity will be high-tech industries—computers, semiconductors, biotech, telecommunications. Furthermore, with capital and technology freer than ever to roam the world in search of low-cost production sites, the West will continue to export the industrial revolution, and will keep importing the low-cost output. Overall, growth will continue moderately even as prices decline. If I'm right, and we soon see deflation of 1% to 2% per year as a steady diet, a target of 3% yields on long-term Treasurys in two years is reasonable. That kind of drop from the current 5% level would pay you 39% on a 30-year coupon bond, plus 10% in interest payments. On a 25-year zero that you roll over every 12 months, you'd gain 75%. Meanwhile, stocks would probably get pounded in the transition to deflation, perhaps losing 40% to 50%. Zero coupon Treasurys are readily available from brokers. I'd go for 25- to 29-year maturities because 30-year zeros can be erratic when initially created by stripping Treasury coupon bonds. If you want less volatility, you can play a milder version of the same game with shorter-maturity zeros or coupon bonds. Stay away from zero coupon municipal bonds; bad things could happen to the issuer before that single, final payment. I would also avoid corporate bonds in an economy in transition to deflation—it's no time to bet on credit quality. A. Gary Shilling is president of A. Gary Shilling & Co., economic consultants and investment advisers, which publishes Insight, a monthly newsletter on the business outlook and investment strategy. His latest book is Deflation (Lakeview Publishing 1998). Web site: www.agaryshilling.com E-mail:[email protected]
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