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From: stern@tilt.FUN
Newsgroups: net.invest
Subject: Re: zero-coupon bonds
Message-ID: <46100002@tilt.FUN>
Date: Tue, 11-Mar-86 14:38:00 EST
Article-I.D.: tilt.46100002
Posted: Tue Mar 11 14:38:00 1986
Date-Received: Wed, 12-Mar-86 22:56:00 EST
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Nf-From: tilt!stern    Mar 11 14:38:00 1986

Here's a little on zero coupon bonds:

1. What They Are

A zero coupon bond (or zero for short) is a bond that pays no interest to you
during its life.  When it matures, you get the face value of the bond from
the issuer.  As a result, they are priced with an implicit yield -- the bond
sells at a deep discount.  To figure out how much a zero coupon bond is yielding,
consider that the yield is the equivalent rate of compound interest your money
would earn if invested elsewhere.  If you invest X dollars for N years at R%
yearly interest, then after the N years you have:

	X' = (1+R)^N * X

Example: invest $100 in a 5% checking account for 2 years.  In 1988 you'd have
 100 * (1.05)(1.05) = $106.25

To determine the yield of a zero-coupon bond, you have X' (the face value of
the bond), you know X (the price you pay for it), and you know N - the number
of years until maturity.  Plug into the equation above and solve for R.  Most
zeros are yielding 9-9.5% right now.

2. Where They Come From

Zeros are issued by corporations (Allied Chemical has lots) or through brokers.
Some corporations will issue them to get some cash now without having to service
the debt for 15-20 years.  Later on, they can just pay off the bonds in one
shot.  The Allied Chemical zeros due in 2006 or so are going for about $130 each
right now.  The other source of zeros is brokers, who sell them as CATS or STRIPS.
CATS stands for Certificates of Accrual on Treasury Securities;  STRIPS is
something similar (Treasury Receipts for Interest....whatever).  As you can
guess, brokers bundle up treasury securities (T-bills and the like) and then
pull off the coupons.  They sell you a certificate representing the bare bond,
with no coupons attached -- they also collect the coupon interest every 6 months.
CATS and STRIPS are usually $1,000 face value bonds and a 20-year zero now
sells for about $230-$250.  Zeros traded on the NYSE are listed in your favorite
financial paper with other NYSE bonds.  They are usually marked zr where the
yield/maturity go in the listings.  The prices listed are per $100 face value,
so multiply by 10 for a $1,000 bond.

3. How to Have $100,000 in 5,10,20 Years

If you want $100,000 in 5 years, buy 100 $1,000 face value zeros due in 1991.
This will probably run you $60,000 plus commissions.  For $100,000 in 20 years,
buy 20-year zeros, which would be about $22,000.  You can tell what the bonds
will be worth at maturity quite easily: it's the face value.  

4. Things to Remember

A. The Feds tax implied interest
The goverment will make you pay taxes on the "interest" your money earned
implicitly while you were holding the zero.  The implicit interest is usually
reflected as a change in the market value of the bond, but there are explicit
formulae for determining it.  Zeros are best purchased for (a) your kids,
who won't pay taxes on that small amount of interest (b) your IRA, where
the interest isn't taxed.  

B. Brokers who sell you STRIPS may hide commissions
Most brokers bundle commissions into the cost of the zero coupon bond.
They'll quote you $260 for a 20-year zero, which may include $30 of their
commission.  When calculating your return, include their commission, not
just the price listed in the bond section of the paper.  Some brokers say
"we don't charge you commission on the bond" and they're right -- they
just set a higher price for the securities they package and sell.

C. Rising interest rates hurt zeros badly
Zeros are priced to yield market rates plus a small premium.  If rates
go up, the market price of your zeros will go down so that the implied
yield increases to the current market yield.  The effect is much more
pronounced with zeros than it is with regular bonds.  As an example of
this effect in reverse, look at the Allied Chemical zr06:  it came out
at about $90, and shot up to $135 when interest rates slid just a little.
A nice 50% gain for people who bought into them.  

--Hal Stern
  Princeton University
  {ihnp4, seismo, allegra}!princeton!stern