Zero Coupon Bonds and TIPS In Taxable Account

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Park
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Zero Coupon Bonds and TIPS In Taxable Account

Post by Park » Sat Jul 13, 2019 7:35 am

I may be stating the obvious in the following, but please point out if I"m missing something.

Assume one is investing in individual zero coupon bonds. I used to think that was tax inefficient. Every year until the bond matures, you have to pay tax on income that you don't receive. Compare it to a coupon bond with the same yield. With the coupon bond, you have to pay tax, but it's on income that you do receive. However, assume that you were going to reinvest in bonds any interest that you receive. The tax with the zero coupon bond will be the same as the nominal bond. However, there's no reinvestment risk with the zero coupon bond and there's no transaction costs associated with reinvestment. So if the plan is to reinvest in bonds, you can make a good case for zero coupon bonds. If you're not planning to reinvest in bonds, then coupon bonds make more sense. To generate income from a zero coupon bond portfolio, you'd have to sell. That would involve transaction costs and exposure to interest rate risk.

Assume one is investing in individual TIPS. First of all, in a taxable account, TIPS don't work as well as an inflation hedge. But at least you have some inflation protection with TIPS in a taxable account, compared to nominal bonds in a taxable account. And if TIPS are priced attractively relative to nominal bonds, then the argument in favor of TIPS is stronger. Just as with zero coupon bonds, tax is payable in TIPS on income that you don't receive. Once again though, if the plan was to reinvest income in the same type of bond, then there will be no transaction costs or reinvestment risk on that "phantom income". Just as with zero coupon bonds however, if the plan isn't to reinvest in the same type of bond, then nominal bonds make more sense.

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vineviz
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Re: Zero Coupon Bonds and TIPS In Taxable Account

Post by vineviz » Sat Jul 13, 2019 10:19 am

Park wrote:
Sat Jul 13, 2019 7:35 am
I may be stating the obvious in the following, but please point out if I"m missing something.

Assume one is investing in individual zero coupon bonds. I used to think that was tax inefficient. Every year until the bond matures, you have to pay tax on income that you don't receive. Compare it to a coupon bond with the same yield. With the coupon bond, you have to pay tax, but it's on income that you do receive. However, assume that you were going to reinvest in bonds any interest that you receive. The tax with the zero coupon bond will be the same as the nominal bond. However, there's no reinvestment risk with the zero coupon bond and there's no transaction costs associated with reinvestment. So if the plan is to reinvest in bonds, you can make a good case for zero coupon bonds. If you're not planning to reinvest in bonds, then coupon bonds make more sense. To generate income from a zero coupon bond portfolio, you'd have to sell. That would involve transaction costs and exposure to interest rate risk.

Assume one is investing in individual TIPS. First of all, in a taxable account, TIPS don't work as well as an inflation hedge. But at least you have some inflation protection with TIPS in a taxable account, compared to nominal bonds in a taxable account. And if TIPS are priced attractively relative to nominal bonds, then the argument in favor of TIPS is stronger. Just as with zero coupon bonds, tax is payable in TIPS on income that you don't receive. Once again though, if the plan was to reinvest income in the same type of bond, then there will be no transaction costs or reinvestment risk on that "phantom income". Just as with zero coupon bonds however, if the plan isn't to reinvest in the same type of bond, then nominal bonds make more sense.
I think you've got it pretty well covered, though I'd favor "tax on income you haven't received yet" over "tax on on income you don't receive".

If you work out the balance of TIPS and zero-coupon nominal bonds right so that the TIPS coupons at least cover the expected tax bill for both, you can minimize your reinvestment costs.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Zero Coupon Bonds and TIPS In Taxable Account

Post by Call_Me_Op » Sat Jul 13, 2019 10:45 am

You seem to be mixing-up tax efficiency with other issues, such as reinvestment risk. Bonds in general are not particularly tax efficient, although treasuries are a bit better than corporates. However, there may be reasons to hold them in taxable account; tax-efficiency is not usually one of them.
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stlutz
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Re: Zero Coupon Bonds and TIPS In Taxable Account

Post by stlutz » Sat Jul 13, 2019 11:25 am

Call_Me_Op wrote:
Sat Jul 13, 2019 10:45 am
You seem to be mixing-up tax efficiency with other issues, such as reinvestment risk. Bonds in general are not particularly tax efficient, although treasuries are a bit better than corporates. However, there may be reasons to hold them in taxable account; tax-efficiency is not usually one of them.
Sometimes the argument gets made/implied that Zero Coupon Bonds & TIPS are somehow worse from a taxation perspective than nominal bonds because of the so-called tax on "phantom income". One needs to look at actual return as opposed to the exact from that those returns are delivered. If I buy a bond for $100 dollars and get a $1 interest payment, that's the same as buying a zero-coupon bond for $90 and having it go up in price to $90.90--these are the same from a return and a taxation perspective. The slight different is if the coupon will be reinvested. Zero-coupon guy is reinvesting at the original rate of the bond purchased (kind of like CD), the regular bond guy will reinvest at prevailing interest rates at the time of the interest payment.

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grabiner
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Re: Zero Coupon Bonds and TIPS In Taxable Account

Post by grabiner » Sat Jul 13, 2019 3:37 pm

I agree with other posters that the "phantom income" argument is primarily behavioral. You need to have some source of cash to pay the taxes if the income which is taxed is not paid to you as a dividend. If you have a bond ladder, you can pay the taxes from the maturing bonds; if you have nothing maturing, you have to have other income or sell something.

TIPS, either individual or in a fund, are pretty good in a taxable account. They are exempt from state tax, and since they are among the least risky bonds, they tend to have low yields and thus low federal tax. (But if you do this, you might consider I-Bonds first; compare the value of the tax deferral to the difference in rates.)
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Park
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Re: Zero Coupon Bonds and TIPS In Taxable Account

Post by Park » Sat Jul 13, 2019 9:51 pm

stlutz wrote:
Sat Jul 13, 2019 11:25 am
Zero-coupon guy is reinvesting at the original rate of the bond purchased (kind of like CD)
One can buy CDs in which interest is automatically reinvested at a predetermined rate. I hadn't thought about it before, but as mentioned above, such CDs are effectively zero coupon nominal bonds with less liquidity.

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#Cruncher
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Re: Zero Coupon Bonds and TIPS In Taxable Account

Post by #Cruncher » Sun Jul 14, 2019 11:14 am

Park wrote:
Sat Jul 13, 2019 7:35 am
The tax with the zero coupon bond will be the same as the nominal bond.
Not quite. The taxes will be slightly higher on a zero coupon bond than on a coupon bond with the same pretax yield-to-maturity (YTM). The following table compares $1,000 invested in a 10-year zero and a 10-year 2% coupon bond purchased at par. Both have a 2% YTM and are subject to a 22% tax rate.

Code: Select all

       --- Zero Bond ---   After Tax Cash Flow
Year    Value   Increase  Zero Bond  Coup Bond

Code: Select all

   0   1,000.00           (1,000.00) (1,000.00)
   1   1,020.00    20.00      (4.40)     15.60 
   2   1,040.40    20.40      (4.49)     15.60 
   3   1,061.21    20.81      (4.58)     15.60 
   4   1,082.43    21.22      (4.67)     15.60 
   5   1,104.08    21.65      (4.76)     15.60 
   6   1,126.16    22.08      (4.86)     15.60 
   7   1,148.69    22.52      (4.96)     15.60 
   8   1,171.66    22.97      (5.05)     15.60 
   9   1,195.09    23.43      (5.16)     15.60 
  10   1,218.99    23.90   1,213.74   1,015.60 
Sum               218.99     170.82     156.00 
After tax return              1.56%      1.56%
The value of the zero for tax purposes increases 2% each year and tax is due on the increase. In the first year this is $4.40 which is the same as the tax due on the coupon bond's $20 annual interest. But the zero's increase in taxable value -- and hence the tax due -- rises every year. So the total tax due on the zero is $218.99 X 22% or $48.18 compared to the $44.00 tax due on the coupon bond's $200.00 interest. However, even with the larger tax bill, the after tax return (computed with the Excel IRR function) is the same as for the coupon bond and equals 2% X (1 - 22%) or 1.56%.

Edit 7:00 PM. Grabiner makes an excellent point in the following post. If I'd realized it, I wouldn't have bothered to make this post. :oops:
Grabiner wrote:The tax difference is caused by the failure to reinvest dividends in the coupon bond, which means that you pay less tax with the coupon bond because you keep less money invested in future years.
Last edited by #Cruncher on Sun Jul 14, 2019 6:01 pm, edited 1 time in total.

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grabiner
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Re: Zero Coupon Bonds and TIPS In Taxable Account

Post by grabiner » Sun Jul 14, 2019 3:44 pm

#Cruncher wrote:
Sun Jul 14, 2019 11:14 am
Park wrote:
Sat Jul 13, 2019 7:35 am
The tax with the zero coupon bond will be the same as the nominal bond.
Not quite. The taxes will be slightly higher on a zero coupon bond than on a coupon bond with the same pretax yield-to-maturity (YTM). The following table compares $1,000 invested in a 10-year zero and a 10-year 2% coupon bond purchased at par. Both have a 2% YTM and are subject to a 22% tax rate.

The value of the zero for tax purposes increases 2% each year and tax is due on the increase. In the first year this is $4.40 which is the same as the tax due on the coupon bond's $20 annual interest. But the zero's increase in taxable value -- and hence the tax due -- rises every year. So the total tax due on the zero is $218.99 X 22% or $48.18 compared to the $44.00 tax due on the coupon bond's $200.00 interest. However, even with the larger tax bill, the after tax return (computed with the Excel IRR function) is the same as for the coupon bond and equals 2% X (1 - 22%) or 1.56%.
The tax difference is caused by the failure to reinvest dividends in the coupon bond, which means that you pay less tax with the coupon bond because you keep less money invested in future years. If you keep the same amount invested (that is, you use the coupon payments to buy more of the same bonds) and the bond yield does not change, the coupon and the zero-coupon bond will have the same dividend and the same investment value every year.
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