Zero Coupon Bonds

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	Making the Most of Zeros Personal Finance Advisor by Deloitte & Touche OnLine October 14, 1996

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.

Example: Mr. Smith purchases a $15,000, 8%, 5-year zero-coupon bond issued by XYZ Company for $10,133.46 on Jan. 1, 1996. He will not receive any cash payments until Dec. 31, 2000, when the bond matures and XYZ Company pays him $15,000.

Tax and Investment Considerations

Investors in zeros must include a portion of the difference between the zero's purchase price and its maturity value in income each year. The investor is entitled to an increase in basis for the amount of the original issue discount (OID) included in gross income. For zeros issued after July 1, 1982, the amount of the OID includable in income is the sum of the daily portions of OID, determined by allocating to each day in an accrual period (six months for zeros issued after 1984) its share of the increase in the adjusted issue price of the zero.

Example: On Oct. 1, 1995, Ms. Jones pays $10,133.46 for a 5-year, zero-coupon U.S. Treasury obligation with a face value of $15,000 and a current yield-to-maturity of 8%. The amount of reportable income for 1996 is $843.30, determined as follows:

Accrual period	Adjusted Issue Price	Daily Portion of OID	Amount Included in Gross Income
Accrual period	Adjusted Issue Price	Daily Portion of OID	1995	1996	1997
10/1/95 - 3/31/96	$10,133.46	$2.25	$202.50	$202.50	0.00
4/1/96 - 9/30/96	$10,538.46	$2.34	0.00	$421.20	0.00
10/1/96 - 3/31/97	$10,959.66	$2.44	0.00	$219.60	$219.60

Because of the taxation of the imputed interest, zeros that produce taxable income (for example, U.S. Treasury and corporate issues) are generally purchased by individuals who have sufficient other cash flow to pay the tax or for tax-deferred accounts, such as IRAs and Keogh plans.

Zeros that produce tax-exempt income (for example, state and local government issues) are often purchased by high-income taxpayers and accounts for children under age 14 who are subject to the "kiddie tax" rules.

Zeros have no reinvestment risk -- that is, the risk that the investor will have to reinvest the annual interest payments at a lower interest rate -- so they may offer lower yields to maturity than comparable conventional or coupon debt issues. In addition, zero-coupon bonds are always more volatile than conventional bond issues because there is no semi-annual interest to reinvest.

Example: Assume Ms. Jones can purchase either a $100,000, 8.5% zero or a conventional bond. The following illustrates the volatility of the zero compared to a conventional bond yielding the same rate, if it is assumed that interest rates immediately rise or fall:

Maturity	Zero-coupon bond			Conventional bond
Maturity	5 years	10 years	20 years	5 years	10 years	20 years
Current Purchase Price	$65,954	$43,499	$18,922	$100,000	$100,000	$100,000
If the interest rate drops to 7%, market value rises to: Percentage increase:	$70,892 7%	$50,257 16%	$25,260 33%	$106,237 6%	$110,659 11%	$116,016 16%
If the interest rate rises to 10%, market value rises to: Percentage decrease:	$61,400 -7%	$37,689 -13%	$14,205 -25%	$94,209 -6%	$90,653 -9%	$87,131 -13%

Other Considerations

To the extent there is a call option attached to the zero that permits the issuer to redeem the bond before its maturity, there is a "call risk," which means that the investor may have to reinvest the proceeds at a lower interest rate. One advantage of U.S. Treasury zeros is that they are noncallable.
Some zeros issued by corporations may be convertible into a fixed number of shares of the issuer's common stock. Some of these zeros may also have a put feature which permits the investor to sell the zero back to the issuer after a stated period for a certain price—generally, at an amount between the purchase price and the redemption price (i.e., the amount that the issuer would have to pay if the bond matured at the time the put is exercised).
U.S. Treasury obligations stripped of their coupons directly by the U.S. Treasury (referred to as "STRIPS") will generally be more liquid than those which have been stripped of their coupons by various investment/brokerage firms (referred to as "proprietary strips" or "synthetic strips"), so the yield on STRIPS may be somewhat lower than on synthetic strips.
Like other fixed-income securities, zeros can be purchased individually or through a mutual fund. Deciding which is better for a particular investor may depend upon his or her financial sophistication, the expenses (management, brokerage, sales, administrative) involved in each choice, whether the zeros will be held to maturity, and the investor's liquidity and diversification needs.

These are just some thoughts to consider. Your tax/financial advisor can provide more detailed information and should be consulted before any action is taken.