Post of the Day
July 2, 1998

From our
Women & Investing Board


Subject: Zero-Coupon Treasury Primer
Author: MikeBuckley

Tony asked about zero-coupon Treasuries.

HOW ARE THEY SOLD?

Glad you asked. When the federal government sells their Treasuries in the marketplace, the coupon is always attached. (The coupon determines the interest paid every six months to the investor.) Only in the secondary market are the bonds stripped of their coupons, resulting in the name "zero-coupon bond" or "strip."

The face value of strips is $1000. The investor buys the strip at a discount to it's $1000 value. When it matures there is a promise to pay the investor $1000, a pomise that's guaranteed by the full faith and credit of the U. S. government.

  "The market decides the cost of a strip by assessing the risk. The longer the maturity, usually the greater the risk."

THE INVESTOR'S RETURN

The investor's return is the average annual increase (or decrease) in price over the time s/he owns the strip. The investor can sell the strip at any time because the Treasury market (including coupon and zero-coupon bonds) is the largest, most liquid financial market in the world. If you never sell the strip, the government pays you $1000 at maturity and you avoid the selling commission.

If you buy a strip with the intent of selling it before maturity you run the risk of selling at a loss. If you wait until the strip matures you are guaranteed a profit. Regardless of how long you hold the strip, there is always the risk that your return might be less than the inflation rate even when your return is profitable.

PERCEIVED RISK

The market decides the cost of a strip by assessing the risk. The longer the maturity, usually the greater the risk. That's because the longer you have to hold the investment to get your guaranteed $1000 from the government, the greater chance there is that inflation will erode the buying power of that $1000. Any time the market perceives greater risk investors require a greater return. The result is that a stripped Treasury's yield to maturity will usually be greater for longer maturities than for shorter maturities. Because the cost of the strip is discounted, as the yield increases the discounted cost decreases. The next section will explain that in concrete terms.

COST -- THE NUMBERS

There are two factors that affect the price of strip, the LENGTH OF MATURITY and the YIELD TO MATURITY. To put the discounted cost of strips into real-world perspective, let's assume some stuff that might have been fairly typical of recent situations. (This won't be an accurate example of the current market which is not typical.)

The impact of the length of maturity is important to understand. Let's assume that two maturities -- 5- and 30-year strips -- are available in the market for the same 5% yield. In that case the 5-year strip will cost about $784 and the 13-year strip will cost only $231. The investor is guaranteed $1000 for each of them when they mature. Because s/he has to wait 25 years longer for the 30-year bond to get the guaranteed thousand smackers, today's cost is far less.

To demonstate the impact of the yield, let's get a little more realistic. In typical markets the 30-year strip will have a higher yield than the 5-year strip. (If the reason for that isn't apparent, go back and review the section, "Perceived Risk," before going forward.) A market that requires a 5% annual return for the 5-year strip might require a 7% return for the 30-year strip. That 30-year, 7% strip will cost only $131, remembering that the 30-year strip yielding only 5% in our earlier example costs a lot more, $231.

To summarize the numbers, the discounted cost of a strip is usually lower for a long-term maturity than for a short-term maturity. If two maturities offer the same yield, the dolar cost of the longer maturity will be less. If the longer maturity also has a higher yield to compensate for the increased risk of inflation, that higher yield drives today's cost even lower.

"The biggest reason [investors like strips] is because of the guaranteed return if held to maturity and the ease of planning that goes with it."  

THE INVESTOR'S RETURN -- THE NUMBERS

Okay, now that we've got a basic understanding of how the length of maturity and the yield affects the cost of a strip today, we'll discuss how the strip increases or decreases over time but prior to maturity.

Let's assume you buy a 30-year strip that has a 10% yield to maturity (as could have happened in previous years when interest rates were much higher than today.) Let's also assume that three years later inflation has decreased and the market requires a lower return. (That also happened.) Three years after you buy your strip investors require only an 8% yield for your strip (which is now a 27-year strip because you've held it for three years.)

Here's the astounding numbers: You buy the 30-year strip yielding 10% for $57 and three years later when interest rates have come down just two percentage points to 8%, the market is willing to pay you $125. That's a short-term average annual return of 30% for an investment that carried a long-term, guaranteed 10% return had you held to maturity.

However, interest rates could have gone up instead of down. Let's assume that three years after you bought the strip interest rates are two points higher at 12%. The market will pay you only $47 for your trip that cost you $57 three years eariler. That's an average annual loss of more than 6% IF you sell.

Remember, though, that you don't have to sell. Remember that the government guarantees you your $1000 payment when it matures. That payment results in an annualized 10% return because of the price you paid when you bought it. Make sense?

RISK/REWARD

The investor's risk/reward scenario is easily seen when looking the interest rate curve, a graph of yields for strips of various maturities. The greatest reward with the least risk is the strip at the "top" of the curve. That's the strip that can be purchased for the greatest yield with the shortest maturity.

It's not easy to explain so I won't try. A picture is worth a thousand words so take a look at an interest rate curve of about five or ten years ago if you can find one. (The interest rate curve doesn't show it very strongly today because it's so flat it's not much of a curve.) The best way I can demonstrate the risk and reward is to suggest that you wouldn't want to buy a 30-year strip yielding 6.1% if you can buy a 20-year strip yielding 6.0%. The additional 0.1% return for the longer maturity doesn't compensate you sufficiently for the risk that inflation will erode your investment over the extra 10 years you have to hold the strip to get your guaranteed $1000.

WHY DO INVESTORs LIKE STRIPS?

The biggest reason is because of the guaranteed return if held to maturity and the ease of planning that goes with it. A parent has a child who will start college in 15 years and buys some 15-year Treasuries knowing EXACTLY how much the investment will be worth. After having saved some more money a year later, the parent buys some 14-year Treasuries for the same reason.

WHY DO I LIKE STRIPS?

The best way to capitalize on zeros is to buy them with the intent of selling when interest rates drop, knowing that if they don't drop you get a guaranteed return until the strip matures.

Ironically, though I took a lot of time to write this little primer, I don't think now is a good time to invest in zeros. Right now thirty-year zeros are guaranteeing a return that is only about half the historical return of stocks over the same period of time.

However, assume the Federal Reserve fails to do its job in the future and allows interest rates on long bonds to go to 15% as happened in the past. If that happens, I know the chances are tremendous that at some time further into the future the high interest rates will choke off the economy, causing it too slow (maybe even causing a recession) and causing interest rates to lower. After rates have gone lower in that scenario, I will be able to sell for a tremendous gain. And if rates don't go lower, I've got a GUARANTEED return over three decades that is 50% greater than the historical return of stocks. Not bad in my opinion.

Hope this helps, and sorry the post is so long.

--Mike Buckley


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