Zero-coupon bond

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Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value.[1]

Characteristics of zero coupon bonds

  • Zero-coupon bonds or “zeros” result from the separation of coupons from the body of a security. Consequently, from a single coupon-paying bond, two bonds result: one which pays the coupons but returns no principal at maturity (an annuity), and one which pays no coupons but returns the par value at maturity (a zero-coupon bond).
  • Zeroes sell at discounts from face value.
  • The difference between the purchase price of the zero and its face value when redeemed is the investor's return.
  • Zeroes can be purchased from private brokers and dealers, but not from the Federal Reserve or any government agency. [2]
  • Zeros have the unique property of having a duration equal to their maturity. This has several consequences for investors:
    • A bond of a given maturity has much greater exposure to interest rate changes than a coupon-paying bond. For instance, a 30-year bond with a 5% coupon has a duration of just over 15 years; by contrast, a 30-year zero has a duration of 30 years. Therefore, in a deflationary crisis where long-term Treasuries are expected to do well, zero-coupon Treasuries (STRIPS) will be the best performers.
    • The duration of a zero, unlike coupon-paying bonds or bond funds (excepting a few target-date bond funds), keeps pace with the reductions in investment horizon as time passes. This property makes zeroes precisely suited for investing to meet a known, fixed future obligation. The lack of availability of inflation-indexed zeroes, however, limits the utility of this property to satisfying only known, fixed, future obligations valued in nominal dollars. It is possible to create a portfolio of individual bonds or of bond funds that approximates this property of zeroes by periodic rebalancing between bonds/funds of different durations, although such a scheme leaves the investor subject to yield curve shifts. Creating a declining-duration portfolio of TIPS, however, would allow the reasonably certain satisfaction of a future obligation valued in real dollars.

Treasury STRIPS

The U.S. Treasury initially opposed stripping of Treasuries into coupon-only bonds (known as annuities) and maturity-only bonds (zeros), because the zero-coupon bonds could be used to exploit a tax loophole. The 1982 Tax Equity and Fiscal Responsibility Act closed this loophole, however, and the same year several private firms were able to create unsanctioned versions on the private market. These issues were not interchangeable on the secondary bond market, making them fairly illiquid. A consortium of primary dealers came together and issued interchangeable zeroes known as Treasury Receipts. In 1985, the Treasury eventually created an authorized version known as STRIPS (Separate Trading of Registered Interest and Principal of Securities)[3], which has replaced the proprietary issues; the program continues to this day. All Treasury issues of 10-year maturity or greater are eligible for stripping. Because STRIPS cannot be purchased directly from the Treasury, purchasers cannot avoid bid/ask spreads.

TIPS STRIPS

The Treasury[3] does facilitate "stripping" TIPS, but no functioning market for TIPS STRIPS exists. Barclays Capital created a stripped TIPS known as iStrips, but they did not sell well and the product was discontinued. [4]

Zero-coupon corporate bonds

Zero-coupon corporate bonds are most prevalent in the high-yield market, where their lack of coupon payments in the first several years provides liquidity in a key period for bonds used to finance acquisitions, restructuring, or other immediate cash flow needs. Many high-yield zero-coupon bonds have a structure which reflects this time series, and in fact begin making coupon payments after 3-7 years of couponless existence.

Zero-coupon bonds, when combined with the call option prevalent in most high-yield securities, cannot be used to provide absolutely certain nominal returns at a given date that zeroes are often used to provide, as an increase in the credit rating of the issuer or a decrease in interest rates would prompt the issuer to call the bond prematurely. They also cannot be used to gain greater exposure to interest rate shifts (e.g. to protect against deflationary crises) as one part of a portfolio, because the negative convexity exhibited by bonds with call options alters the picture somewhat and in ways not favorable to the investor.

Zero-coupon municipal bonds

Municipal zero-coupon bonds exist, including bonds called "municipal multipliers," in which coupon payments are made but re-invested at the bond's yield. These variations are generally in place to avoid legal restrictions on the amount of liability that issuers were allowed to create.

Another variation of a municipal zero-coupon bond is the Convertible Zero Coupon Municipal Bond (varieties include GAINS (Growth and Income Securities): FIGS (Future Income and Growth Securities) [5] and STAIRS (stepped tax-exempt appreciation on income realization securities). [6] These bonds start as zero coupon bonds and then, generally after eight to 15 years, convert to interest-paying bonds. These bonds appeal to retirement investors who like the tax exempt appreciation of the security up to a retirement date, followed by a conversion to a coupon paying security that provides an income stream during retirement. [7]

Tax aspects

Zeroes do not return the accrued interest until the bond matures, but the IRS taxes the income as it is accumulates each year. Therefore, zeroes are best held in tax-advantaged accounts to escape this taxation on "phantom income." STRIPS, as issues of the Treasury, are exempt from state and local taxation. Zero-coupon bonds issued by municipalities may be exempt from Federal taxation as well.

Zero-coupon bond funds

American Century offers two Target dated zero-coupon bond funds, set to mature and liquidate by a set maturity target date. Although it is convenient to purchase as a mutual fund, an investor should carefully compare the 0.57% expense ratio (which is paid every year) to the commission and bid/ask spread of purchasing a zero-coupon bond directly. In many cases (particularly long-dated bonds where you are planning to hold to maturity), purchasing the bond directly will likely cost less.

Vanguard offers an index fund, the Extended Duration Treasury Index Fund, based on the Barclays U.S. Treasury STRIPS 20–30 Year Equal Par Bond Index. Unlike the American Century funds, this fund has no set maturity date, as the maturity is meant to remain at around 25 years. The fund is only available in institutional and ETF shares.

References

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Papers