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Bloopers & Blunders: Zero-Coupon Bonds as an Investment Vehicle

Explaining the potential advantages of zero-coupon bonds as a retirement investment vehicle, consider the following quotation (WSJ, May 29, 1996):

Quotation

"Suppose you want at least $100,000 when you retire 20 years from now. You can buy 100 20-year Treasury strips, each with a face value of $1,000. Your cost: about $25,000, including a broker's markup of some $675. Your yield would be about 7%. [Paragraph 1]

If rates drop this year, with new strips yielding 6.5%, you could sell yours, pocketing a 21% gain. [Paragraph 2]

Of course, if interest rates rocket higher, with new strips yielding 8%, you would lose 7% if you sold. But even that would hurt less than a 10% to 35% plunge in the stock market, which Mr. Floyd figures is as much as stock prices could fall. [Paragraph 3]

 And if you held the strips until they matured -- or until rates fell again -- you would be guaranteed to gain. Stocks offer no such assurance. [Paragraph 4]

‘People who buy zeros and hold them can rest assured they'll get a set return,’ says Richard Lehman, editor of Income Securities Advisor, a Miami newsletter. [Paragraph 5]

Zero-coupon bonds offer more certainty than conventional, interest-paying bonds, which provide most or all of their return as interest income. There isn't any coupon to reinvest with a strip, so investors don't have to worry about what rate they would earn on reinvested interest payments." [Paragraph 6]

Some Definitions

Zero-coupon Bonds are bonds that pay a single cash flow, the face value, at maturity.

Strips are financial assets created by investment firms by splitting Treasury bonds into components: coupons and face value. The latter becomes in effect a zero-coupon bond.

Analysis

1. Compare the numbers in paragraphs 2 and 3. In the former paragraph, it says that if the yield (i.e., interest rate on these bonds) goes down by .5%, from 7% to 6.5%, you would make a 21% gain. However, in paragraph 3, if yield goes up by the same amount you only lose 7%. Does not make any sense.
2.  Without going into the mathematics of measuring the impact of change in interest rates on bond prices, one would think that the percentage change from a given level should be the same whether the yield goes up or down. This concept, if you remember from your microeconomics, is called elasticity, i.e., the percentage change in price as a result of a 1% change in yield. That is, if yield changes (up or down) by, say, .5%, then the price of the bond should change (down or up) by, say, X%. The concept is called "duration" in finance.

    Let’s use the numbers in paragraphs 2 and 3. A .5% decrease in yield is causing a 21% gain but the same percentage increase in yield is only causing a 7% loss!

3. Consider "guaranteed to gain" in paragraph 4. At best this is misleading. This is an accounting gain, in that you will end up will more dollars than you started with. There is no guarantee that the value of the additional dollars represents a true gain if interest rates go up. If you include the opportunity cost of tying up your money in such an asset with interest rates going up, you are losing money; not gaining.
   
4. Consider "more certain" in paragraph 6. The author seems to have forgotten that there is more than one source of risk associated with a bond; only the reinvestment risk is being considered here. Actually the lower the coupon rate, other things being equal, the higher the volatility of prices as a result of changes in interest rates, i.e., less, not more, certain. The intuition is simple: with coupon bonds you are receiving cash flows over the life of the bond as opposed to obtaining all your value from a single cash-flow at maturity.

By Alex Tajirian