Zero Coupon Bonds Chapter 7 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Zero-coupon bonds are sold at a deep “original” issue discount from their face value. –Investors receive the face value at maturity. Rather than periodic interest payments –They are issued by corporations and governmental entities. Some zero-coupon bonds issued by state and municipal governments are tax-exempt.

Zero Coupon Bonds Chapter 7 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 When is the use of this tool indicated? Investors know their exact yield to maturity. –They do not have to worry about reinvesting cash flows at, perhaps, lower rates of interest than they are receiving on the bond. –If the bond is held to maturity and does not default, the return is guaranteed. –This is particularly important when investors wish to “lock in” a rate of return and be assured of a specified accumulation at a given future date. Taxable zeros are very attractive conservative investments for retirement plans. –The tax shelter feature of the retirement plan allows the unpaid, but otherwise taxable accruing, interest to be tax deferred.

Zero Coupon Bonds Chapter 7 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 When is the use of this tool indicated? Tax-exempt zeros are suitable conservative investments for high-tax-bracket investors who: –Wish to accumulate wealth –Have little need for current cash flow –Do not desire to worry about reinvestment of cash flows. Zero-coupon securities are frequently used to meet specific financial or investment goals. –Particularly applies when the date of a future need is known well in advance

Zero Coupon Bonds Chapter 7 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 Advantages / Disadvantages Investors must forego the opportunity to reinvest at higher rates if market interest rates rise. –This is the caveat to the certainty investors receive that the reinvestment rate will be equal to the yield to maturity if the bond is held to maturity. Prices of zero-coupon bonds are much more sensitive to changes in interest rates than coupon bonds of comparable term and quality. –If an investor has to sell a zero-coupon bond before maturity, there is no assurance that he will realize the anticipated yield. Many zero-coupon bonds are callable at the discretion of the issuer. –If the bond is called before maturity, the investor will generally not be able to reinvest the proceeds at the yield to maturity he enjoyed on the zero-coupon bond.

Zero Coupon Bonds Chapter 7 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Tax Implications The investor must generally include accruing interest in his taxable income, even though no cash is received until the bond matures, is sold, or is called. –This does not apply to tax-exempt issues.

Zero Coupon Bonds Chapter 7 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Alternatives Deep discount, low-coupon bonds –Also known as market discount bonds –Depending on the coupon rate and the remaining time to maturity, investors may acquire such low-coupon bonds at substantial discounts from their face values. –Investors are assured that the portion of the interest that is cash deferred until the bond matures will be effectively reinvested at the original yield to maturity. Similar to zero coupon bonds