Subject: Bonds - Zero-Coupon

Last-Revised: 28 Feb 1994
Contributed-By: Art Kamlet (artkamlet at aol.com)

Not too many years ago every bond had coupons attached to it. Every so often, usually every 6 months, bond owners would take a scissors to the bond, clip out the coupon, and present the coupon to the bond issuer or to a bank for payment. Those were "bearer bonds" meaning the bearer (the person who had physical possession of the bond) owned it. Today, many bonds are issued as "registered" which means even if you don't get to touch the actual bond at all, it will be registered in your name and interest will be mailed to you every 6 months. It is not too common to see such coupons. Registered bonds will not generally have coupons, but may still pay interest each year. It's sort of like the issuer is clipping the coupons for you and mailing you a check. But if they pay interest periodically, they are still called Coupon Bonds, just as if the coupons were attached.

When the bond matures, the issuer redeems the bond and pays you the face amount. You may have paid $1000 for the bond 20 years ago and you have received interest every 6 months for the last 20 years, and you now redeem the matured bond for $1000.

A Zero-coupon bond has no coupons and there is no interest paid.

But at maturity, the issuer promises to redeem the bond at face value. Obviously, the original cost of a $1000 bond is much less than $1000. The actual price depends on: a) the holding period -- the number of

years to maturity, b) the prevailing interest rates, and c) the risk involved (with the bond issuer).

Taxes: Even though the bond holder does not receive any interest while holding zeroes, in the US the IRS requires that you "impute" an annual interest income and report this income each year. Usually, the issuer will send you a Form 1099-OID (Original Issue Discount) which lists the imputed interest and which should be reported like any other interest you receive. There is also an IRS publication covering imputed interest on Original Issue Discount instruments.

For capital gains purposes, the imputed interest you earned between the time you acquired and the time you sold or redeemed the bond is added to your cost basis. If you held the bond continually from the time it was issued until it matured, you will generally not have any gain or loss.

Zeroes tend to be more susceptible to prevailing interest rates, and some people buy zeroes hoping to get capital gains when interest rates drop. There is high leverage. If rates go up, they can always hold them.

Zeroes sometimes pay a better rate than coupon bonds (whether registered or not). When a zero is bought for a tax deferred account, such as an IRA, the imputed interest does not have to be reported as income, so the paperwork is lessened.

Both corporate and municipalities issue zeroes, and imputed interest on municipals is tax-free in the same way coupon interest on municipals is. (The zero could be subject to AMT).

Some marketeers have created their own zeroes, starting with coupon bonds, by clipping all the coupons and selling the bond less the coupons as one product -- very much like a zero -- and the coupons as another product. Even US Treasuries can be split into two products to form a zero US Treasury.

There are other products which are combinations of zeroes and regular bonds. For example, a bond may be a zero for the first five years of its life, and pay a stated interest rate thereafter. It will be treated as an OID instrument while it pays no interest.

(Note: The "no interest" must be part of the original offering; if a cumulative instrument intends to pay interest but defaults, that does not make this a zero and does not cause imputed interest to be calculated.)

Like other bonds, some zeroes might be callable by the issuer (they are redeemed) prior to maturity, at a stated price.

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