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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 35367  
Subject: Re: Buying Zeros & Dealing with Call-Risk Date: 4/21/2009 2:45 PM
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Paul,

I totally agree with the points you made. (1) Zeros are best held in tax-sheltered accounts, and (2) the zero had better be of such high quality that default-risk isn't a worry.

On that latter point, I would never make an exception. Before so many top-tier companies were down-graded by one notch, I used to restrict my buying to AAA/Aaa's. These days, one has to make intelligent exceptions to that rule. Thus, I would call Toyota a suitable candidate for buying their zeros (and Bershire if they issued them), but not the banksters like Merrill and Morgan (unless, of course, the price were compelling and the maturity near-by). But, even then, I'd probably pass.

Also, if I have to pay much more than 30, a lot of the attraction of a zero fades away. What I use zeros for is to soak up idle cash that is too small to put toward a more substantial position, like five of something priced near par. Thus, for me, buying zeros is more a "cash management" strategy than an investment strategy. I can either let a thousand or so sit idle in an account earning 0.005% (or whatever the broker is paying), or I can reach for 7% or so with that cash. But as I said, typically the zero gets called, and I end up sometimes making as much as 10%. So that's the upside of call-risk, better than expected returns.

The times I've bought and held zeros in a taxable account were when they were Agencies that were state-tax exempt, or when I didn't have enough cash in a tax-sheltered account to do a trade that needed to be done. Then I'd execute anyway, to get the zeros in my account, and simply pay taxes on the OID as just a part of doing business. In retrospect, it's a rare trade that is executed flawlessly and works out superbly. But at the time, it really was the best thing that could have been done. So I execute, and I don't worry about the coulda/shoulda/woulda. Second-guessing just leads to paralysis, and then nothing gets done, not even the "good-enough". So I buy zeros whenever I can find them and don't worry that the trade might be less than optimally efficient.

Charlie
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