Uncertain times point to zero coupon bonds

Healthcare Financial Management, April, 1991 by William G. Kistner

Uncertain times point to zero coupon bonds

As the Persian Gulf War went into its second week, an auction of U.S. Treasury Bills produced the lowest rate in nearly three years. Meanwhile, the recession appeared to have bottomed out. For these reasons, views on the economy and future interest rates may be conflicting.

As a result, current financial goals such as retirement or education may best be funded by an investment that will generate a fixed predictable yield in the future. One type of investment yielding a fixed dollar amount is a zero coupon bond, which may be issued by corporations, tax-exempt organizations, or the U.S. government. Rather than paying interest currently, a zero coupon bond is sold at a discount from face value. The difference between the purchase price and the face value is the interest earned over the term of the bond.

One of the benefits of a zero coupon bond is its predictable yield at maturity. Unlike holders of regular bonds paying interest at different intervals, zero coupon bond holders need not be concerned about reinvesting interest receipts as they are paid out.

For example, for a regular bond bearing an annual coupon rate of 8 percent, the yield at maturity is not 8 percent, because interest payments must be reinvested at the rate of interest prevailing at the time of receipt. With a zero coupon bond, this is not the case. A zero coupon bond's interest is continuously reinvested as the value of the bond increases from its purchase price to the ultimate face value at maturity.

Volatility. Because a zero coupon bond holder receives neither principal nor interest during a holding period, prices can be particularly volatile. The longer the maturity, the more volatile the bond.

For example, the value of a zero coupon bond with a 20-year maturity would increase by approximately 20 percent if interest rates fell by 1 percent. At the same time, if interest rates rose by 1 percent, the bond would lose approximately 20 percent of its value. If the bond's maturity were extended to 30 years, a 1 percent decline in rates would lead to a more than 30 percent increase in value.

This type of volatility has its pros and cons. For those wanting to speculate, the rewards or losses can come quickly and dramatically. For a long-term investor who is forced to sell before the bond's maturity, losses can be substantial.

The zero coupon bond issued by the U.S. Treasury is the most common type and the bond of choice of the most conservative investors. Because it is a government bond, no credit risk exists. As a result, the amount due upon maturity is secure.

Yield. The ultimate return on a zero coupon bond depends on two factors, the interest rate at the time it is issued and the term to maturity. For example, a $1,000, 6.5 percent bond maturing in 30 years would cost, before commissions, approximately $147. At the end of 30 years, the bond would be redeemed for $1,000.

The Internal Revenue Code requires that interest on zero coupon bonds be recognized (taxed) annually over the term to maturity, even though no cash is received until the bond matures or is sold or redeemed. As a result, zero coupon bonds issued by taxable entities, such as the U.S. government and corporations, are best held by retirement plans such as individual retirement accounts and Keogh plans. In this way, the "paper income" can be sheltered.

Zero coupon bonds issued by tax-exempt organizations are not subject to these rules, of course, but may be subject to state income tax. Some states, such as Illinois, issue zero coupon bonds for funding college education needs. These bonds are "doubly" exempt: They are exempt from Federal and state income tax. And because ownership can remain with a parent, several financial and tax goals can be achieved.

As of December 1990, 30-year U.S. Treasury bonds were quoted at about 8.5 percent, returning about 12 times an original investment at maturity (before tax). Zero coupon bonds can be purchased directly form a broker through a mutual fund or a unit trust.

Individuals interested in investing in zero coupon bonds should consider not only the tax treatment and the rating of the bond but also the bond's call features. In these uncertain times, zero coupon bonds are an effective way of funding certain types of future needs.

William G. Kistner, CPA, is a tax partner with Ernst & Young in Chicago, Ill. Reader's comments and questions are encouraged and can be addressed to: William G. Kistner, CPA, Ernst & Young, 150 S. Wacker Dr., Chicago, IL 60606.