From: ask@cbnews.cb.att.com (Arthur S. Kamlet)
Subject: Zero-Coupon Bonds (was: Re: misc.invest FAQ)
Organization: AT&T Bell Laboratories,  Columbus, Ohio
Date: Mon, 16 Nov 1992 22:41:26 GMT
Keywords: invest, stock, bond, money, faq

In article <investment-faq/general_721890008@informatik.uni-kl.de> lott@informatik.uni-kl.de writes:
>Archive-name: investment-faq/general
>Last-modified: Mon Nov 16 06:00:02 MET 1992 
>Compiler: Christopher Lott, lott@informatik.uni-kl.de
>
>This FAQ addresses issues pertaining to money and investment instruments,
>specifically stocks, bonds, and other goodies like gold and real estate.
...
>TABLE OF CONTENTS (* means answer needed)
>    Sources for Historical Stock Information
...
>    * Zero-coupon bonds

Not too many years ago every bond had coupons attached to them.
Every so often, usually every 6 months, bond owners would take a
scissors to the bond, clip out the coupon, and present the coupon to
the bond issuer or to a bank for payment.  Those were "bearer bonds"
meaning the bearer -- the person who had physical possession of the
bond -- owned it.  Today,  many bonds are issued as "registered"
which means even if you get to touch the actual bond at all, it will
be registered in your name and interest will be mailed to you every
6 months. It is not too common to see such coupons. Registered bonds
will not generally have coupons, but may still pay interest each
year.  It's sort of like the issuer is clipping the coupons for you
and mailing you a check.  But if they pay interest periodically,
they are still called Coupon Bonds, just as if the coupons were
attached.

When the bond matures, the issuer redeems the bond and pays you the
face amount.   You may have paid $1000 for the bond 20 years ago and
you have received interest every 6 months for the last 20 years, and
you now redeem the matured bond for $1000.

A Zero-coupon bond has no coupons and there is no interest paid.

But at maturity, the issuer promises to redeem the bond at face
value.   Obviously, the original cost of a $1000 bond is much less
than $1000.  The actual price depends on: a) the holding period
-- the number of years to maturity, b) the prevailing interest rates,
and c) the risk involved (with the bond issuer).

Taxes:     Even though the bond holder does not receive any interest
           while holding zeroes, in the US the IRS requires that you
"impute" an annual interest income and report this income each year.
Usually, the issuer will send you a Form 1099-OID (Original Issue
Discount) which lists the imputed interest and which should be
reported like any other interest you receive. There is also an IRS
publication covering imputed interest on Original Issue Discount
instruments.

For capital gains purposes, the imputed interest you earned between
the time you acquired and the time you sold or redeemed the bond is
added to your cost basis.  If you held the bond continually from the
time it was issued until it matured, you will generally not have any
gain or loss.

Zeroes tend to be more susceptible to prevailing interest rates,
and some people buy zeroes hoping to get capital gains when interest
rates drop.  There is high leverage.   If rates go up, they can
always hold them.

Zeroes sometimes pay a better rate than coupon bonds (whether
registered or not).  When a zero is bought for a tax deferred
account, such as an IRA, the imputed interest does not have to be
reported as income, so the paperwork is lessened.

Both corporate and municipalities issue zeroes, and imputed interest
on municipals is tax-free in the same way coupon interest on
municipals is.  (The zero could be subject to AMT).

Some marketeers have created their own zeroes, starting with coupon
bonds, by clipping all the coupons and selling the bond less the
coupons as one product -- very much like a zero -- and the coupons
as another product.  Even US Treasuries can be split into two
products to form a zero US Treasury.

There are other products which are combinations of zeroes and
regular bonds.   For example, a bond may be a zero for the first
five years of its life, and pay a stated interest rate thereafter.
It will be treated as an OID instrument while it pays no interest.

(Note:  The "no interest" must be part of the original offering; if
a cumulative instrument intends to pay interest but defaults, that
does not make this a zero and does not cause imputed interest to be
calculated.) Like other bonds, some zeroes might be callable by the
issuer (they are redeemed) prior to maturity, at a stated price.
-- 
Art Kamlet  a_s_kamlet@att.com  AT&T Bell Laboratories, Columbus
Xref: sparky misc.invest.real-estate:990 misc.forsale:31605 ba.market.housing:3985