These days, many parents seem to be drawn even more strongly to zero-coupon bonds, a favored way to turn today’s money into tomorrow’s tuition. But to earn high marks, buyers must crack the books.
Unlike regular bonds, which give investors periodic interest payments, zeros plow the payments back into the investment and pay the investor everything at maturity.
Their charm is certainty. Used for retirement, cruises and down payments as well as school expenses, these bonds “give you a known amount at a known time,” said James Lebenthal, a municipal bond dealer in New York.
For a set sum now, he said, “parents know that come the year 2006 they’ll have Princeton paid for,” assuming college costs follow a predictable path.
Zero bonds are good for savers, too; no one can fritter away interest payments not received. And, especially for longer maturities, interest can be a big part of the pie. “A $10,000 municipal zero due in 11 years would now sell at around $5,000,” Lebenthal said.
Zeros also have zippier yields than coupon-bearing bonds because of the deferred interest payments, said Mark Wright, an analyst with Morningstar, the fund research company. While a regular Treasury due in 2004 yields 7.57 percent, the zero-coupon version returns 7.71 percent.
But zeros have limits.
Consider inflation, said John Markese, president of the American Association of Individual Investors in Chicago. “You may get $10,000 in the future for $5,000 today, but that $10,000 is not adjusted for inflation.” Investors can project inflation, though such estimates can err greatly, particularly for long time periods.
Such time spans reveal another limit of zeros. “If you have 18 years to get the tuition, use equities, not bonds,” Markese said. Long horizons give stocks growing power and reduces their risk, he said.
Then come the zigzags in zeros’ prices as interest rates move. “Zeros are very volatile,” Wright warned. A Treasury due in 2016 has a duration of 10.3, meaning its value will rise or fall 10.3 percent with each 1 percent fall or rise, respectively, in rates. But if that same bond is a zero, duration jumps to 20.5.
Zeros’ odd traits can trip up even studious investors. One common misconception concerns taxes.
Many people believe that no taxes are owed on zeros until maturity, said James Flynn, a vice president at Chase Manhattan. But they are wrong. If the zero is neither tax-free nor in a tax-deferred account, “people must pay tax on the `phantom income’ during its life,” he said.
Investors must also be wary of volatility. In theory, as “buy and hold” investors, most holders of zeros need not worry about price shifts; if the bonds are held to maturity, their owners will receive the principal and interest, wherever prices have gone.
But investors who plan to buy and hold may find that they need the money before maturity. The lesson: Given zeros’ extreme volatility, be sure you can buy and hold unless you are a speculator.
Jeffrey Tyler, who oversees several zero-coupon funds run by the Benham fund family in Mountain View, Calif., has another lesson for the buy-and-hold set.
Called the Benham Target Maturities series, his funds invest in Treasuries of a designated maturity. Tyler is pleased at the funds’ recent turnabout. After heavy 1994 losses, 1995 returns so far range from a healthy 1.71 percent to 3.93 percent. Yet, he shoos those who buy and hold away from his funds.
The funds’ yearly fees of about 0.6 percent of assets make them costly for such investors, who will pay less by buying the bonds directly, he explained.
His funds work best for active traders who are lured by the zeros’ volatility. For them, the fund expenses are low compared with the broker bills that their frequent transactions would otherwise incur.
And Lebenthal waved investors away from tax-free bonds. “The supply of zeros is so thin in the municipals market that prices are out of whack,” he said. Indeed, contrary to the normal situation, coupon-bearing municipal bonds are now yielding more-and thus costing less-than comparable zeros.
In buying zeros directly, investors confront more complexities. Banks often charge a flat fee, from $50 to $100, for these bonds. Brokers impose a markup, which is keyed to the bond’s face amount and which rises as maturities lengthen.
Merrill Lynch charges $1 for every $1,000 of bonds for maturities of three months or less and up to $7.50 per $1,000 for longer terms. Discount brokers? They often mix these approaches.
How can investors compare apples with oranges with a blend of both? They cannot. Instead, they must get a uniform measure of cost.
First, select an appropriate bond-say, $10,000 of a Treasury that matures in 2005. “Then call three or four sellers and ask for the net yield,” which factors in any fees, Flynn advised. The higher the yield, the better the deal. Many brokers always provide this net, or true, yield, but some may need to be asked.
Alternatively, ask the sellers what the cash outlay for the bond is. The seller with the highest yield should also require the smallest outlay.
