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Course 204
Zero-Coupon Securities

Introduction

Zero-coupon bonds offer you a deal: give up the interest payments you would get from owning other kinds of debt instruments and get a hefty guaranteed lump sum at the end--as long as the issuer does not default!

What Are Zero Coupons?

Like bonds, zero-coupon securities are debt instruments issued by the U.S. Treasury, municipal governments, corporations, and brokerage firms.

With traditional bonds, the coupon rate is the rate of annual interest the issuer pays to the bondholder. The "zero" in "zero coupon," then, means that this kind of security does not make any interest payments, as bonds do.

Why would anyone go for that deal? Because zero coupons are issued at discounts usually far below the face value, or par, of the security. For example, if a company sells you a $1,000 bond for only $700, it's a zero-coupon bond.

As with bonds, the issuer pays the holder the par value when the instrument reaches its maturity date. So, while your zero coupon will not make regular interest payments while you hold it, it will pay out much more than you paid for it when it matures. While this growing value appears to be similar to the capital appreciation of an investment in stocks, it is essentially compounding interest income, not a capital gain.

Types of Zero-Coupon Securities

There are as many kinds of zero-coupon securities as there are bonds, plus a number of interesting variations.

Corporate zeros: These are corporate bonds, done zero-style. Because you are buying into the credit risk of the corporation, corporate zeros are the most risky kind of zero coupon. These are even riskier than a corporate coupon bond (or registered bond), because if the issuing company defaults on the zero, the holder receives no interest at all.

Strips: Strips are zeros that are backed by government securities and offered by brokerage houses. Brokerages are proliferating their own proprietary brands of strips under a dizzying array of acronyms: TIGRs, CATS, and other species. Each has different features but works in a similar way. The brokerage buys either U.S. government or municipal securities and holds them in escrow. It then separates--strips--the principal from the interest and markets zero certificates based on one or the other. One example is the Salomon Brothers CATS (Certificate of Accrual on Treasury Securities), a zero in which the face value is based on the accrued value of the underlying Treasury securities.

STRIPS: The Treasury also offers STRIPS--which stand for "separate trading of registered interest and principal of securities"--based on Treasury bonds. Some of the venerable U.S. savings bonds are actually forms of zeros as well.

Municipal zeros: Municipal and state governments also issue zeros in the form of zero-coupon municipal bonds, which frequently have lower returns but are generally tax-free on the federal level.

Zero-coupon convertibles: Finally, zero-coupon convertible bonds can be changed from zeros to other kinds of securities. Companies may issue zero-coupon bonds that may be converted into shares of common stock in the company. Convertible municipal zeros can change from zero coupon to regular interest-paying bonds at some time before maturity.

Strategic Considerations of Zero Coupon Securities

Zero coupon bonds share many of the characteristics of other types of bonds, with one important exception. Since they do not feature regular interest payments, they are not an income investment, as other bonds are, but should be considered an appreciation investment.

It is important to remember, however, that unlike the growth in value of a stock portfolio or mutual fund, the appreciating value of a zero is really a representation of accrued compound interest, and is taxed as such--not as capital gains, which are taxed at lower rates. There are, however, a variety of tax-free government zeros available. Zeros are also suitable in an IRA or other tax-deferred or tax-free plan since they make no distinction between capital gains and ordinary income for tax purposes.

Since zeros are debt instruments, the risk involved depends largely on the credit strength of the issuer. Zeros backed by government securities like U.S. Treasury bonds have very low credit risk, while corporate zeros can be much riskier. If the issuer does default, you may be out quite a bit, because you have not received any interest payments. Also, as with other bonds, the real values of zeros depend on how the returns compare with prevailing interest rates--a factor that makes zeros quite volatile on the secondary market. As a result, most investors hold zeros to maturity.

Zeros Are a Unique Twist on Bonds

Zero-coupon securities offer investors good returns and the security of bonds at a significant discount from their par value. There are special risks and tax considerations that go with zeros, and the ever-proliferating variety of zeros requires careful study of a number of strategic considerations.

Quiz 204
There is only one correct answer to each question.

1 A zero-coupon security is issued at a price________ its par value.
a. Far below
b. Equal to
c. Above or below
2 What does the "zero" in zero coupon mean?
a. The security has no par value.
b. The security does not mature.
c. The security does not pay any interest until maturity.
3 Which statement is true about corporate zero-coupon convertible bonds?
a. They are based on either principal or interest.
b. They can be converted from a bond to shares of company stock.
c. They cannot be stripped.
4 What are zero-coupon strips based on?
a. The interest on a government securities
b. The principal of government securities
c. Either A or B
5 What does the relative value of a zero depend on?
a. The credit of the issuer
b. Interest rates
c. Both A and B
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