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Author: junkman02 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Buying Zeros & Dealing with Call-Risk Date: 4/21/2009 1:15 PM
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A zero-coupon bond (also called a discount bond or just a “zero”) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have so-called "coupons." Investors earn return from the compounded interest all paid at maturity plus the difference between the discounted price of the bond and its par (or redemption) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, and long-term, zero-coupon, corporate bonds. http://en.wikipedia.org/wiki/Zero-coupon_bond

Zeros appear in the secondary-market offering lists only infrequently. They should always be investigated, and (IMHO, ‘natch) they should always be bought, provided:
(1) They can be held in a tax-sheltered account (so taxes don’t have to be paid annually on the phantom interest).
(2) The issuer is high quality.
(3) The yield to worst (YTW) is satisfactory.

Using those guidelines, I have never lost money on a zero. In fact, due to calls, I have typically made more than the projected YTM. So that’s one of the important issues to consider. If the YTW is acceptable, how good might be the YTC? That can be estimated with a bit of simple arithmetic. The “call schedule” for a bond will list the date of the possible call and the amount of principal returned to the note holder. Here is a partial example for Toyota’s 0’s of ’37:

5/5/2009 15.586
5/5/2010 16.656
5/5/2011 17.799
5/5/2012 19.021
5/5/2013 20.326
5/5/2014 21.721
5/5/2015 23.212
5/5/2016 24.806
5/5/2017 26.508
5/5/2018 28.328

As can be inferred from dividing a successor year’s call from a predecessor’s, the implied rate of return is ~6.684%. What the YTM will be can be projected by dividing par by the all-in entry price. Using the holding period will determine the proper compound root (aka, the IRR).

Today is 04/21/09. Maturity is 05/05/37. Therefore, the holding period is 28.06027397 years. At an all-in price of 14.747, the YTM is 7.0595%. Round that 7.06%. That’s not a great return. But Toyota’s ratings are Aa1/ AA+, one notch below top-tier. It’s a company that’s likely to endure and prosper. So default-risk isn’t a worry. Due to the long-datedness of the bond, inflation-risk is a worry. The return of interest and principal is a very far-off event. One’s expectation has to be that purchasing power will be severely degraded. OTOH, zeros are as maintenance-free a bond are there are, and their entry price is very easy on investment budgets. So buying zeros is a lazy way to use small amounts of money now to make larger amounts available later. I like “lazy”, hassle-free investments. So whenever I can find them, I buy zeros.

To my way of looking at value, 7% for high-quality debt is satisfactory, even if it is long-term debt. However, what is the YTM to the nearest call, which is next month? A whopping gazillion percent, right? That won’t happen, of course, otherwise the bond wouldn’t be trading at 14 something. But what abut a call in five years, the 05/05/14 call @21.721? What would be that YTM? The holding period would be 5.043835616 years, and the YTM would be 7.9798962%. Round that to 7.98%. That would be more better yet than the YTM in '37 of 7.06%. What about a call in ten years? What would be the YTM? Some lesser amount than the 5-year call, but a greater amount than the 28-year call, which is maturity.

As maturity is approached, the YTM diminishes until the YTM becomes the YTW. If the bond is called before maturity, the bond holder makes better money. If the bond isn’t called, the bond holder only makes the initially projected YTM, which he already had determined was satisfactory to him, given his overall portfolio objectives. On the basis of my experience with zeros, Toyota will call that bond. I don’t know when. So that’s the “call-risk” of the situation, a risk I accepted this morning when I bought five of those zeros with some IRA cash.

Charlie
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