Zero-coupon bonds, a major component of the package of cash and securities offered by Occidental Petroleum Co. in its bid to take over Cities Service Co., are a relatively new and untested form of corporate debt that could rise in value if Congress enacts the pending tax bill, but fall if there is a new surge in interest rates.
Uncertainty about the tax status and long-term potential of the bonds is one reason that no firm dollar value could be attached to Occidental's offer, tax experts and financial analysts said.
Unlike conventional corporate bonds, which pay interest semiannually to their holders, zero-coupon bonds pay no interest. They are sold for a specified amount today, and return a specified larger sum at maturity. The designation "zero coupon" comes from the absence of the coupons attached to traditional corporate bonds and sent in by the holders to claim their interest payments.
The creation of zero-coupon bonds was "dictated by the Koran," one New York analyst said yesterday in a reference to the Moslem holy book's ban on usurious interest. In the 1970s European financiers developed them as a way to sell securities to Arab investors without violating that prohibition, she explained.
The first U.S. corporation to sell them to the public was J.C. Penney Co., which last year sold for $35 million bonds that will pay $100 million at maturity. In April of this year, Allied Corp. floated what is apparently the biggest zero-coupon issue so far, a $450 million package.
In Occidental's offer, a holder of a share of Cities Service stock, which was selling at $33.25 when trading was halted on Friday, would receive one-third of a share of Occidental preferred stock, which Occidental said is worth $100 a share, and a zero-coupon note that would pay another $33.33 at maturity, beginning in 1985.
According to Wall Street analysts, however, the zero-coupon bond is not attractive to investors with taxable income because, under current law, the total anticipated return is amortized equally over the life of the bond for tax purposes, and the holder is taxed on income not yet received.
A recent issue of Standard & Poor's Outlook newsletter warned investors that "it is necessary to avoid the original issue deep-discount bonds [including zero-coupon issues] that have been marketed in recent months" unless they are held in a tax-sheltered portfolio such as an Individual Retirement Account. The warning did not apply to zero-coupon bonds issued by state and local governments, which are generally exempt from taxation and which "enable the investor to take the fullest possible advantage of the extraordinarily high interest rates that prevail today."
The $99 billion tax bill on which congressional conferees agreed over the weekend would change the tax liability on zero-coupon bonds to favor investors. Instead of assuming that the value of the investment increased by an equal amount each year, it would reflect the way compound interest actually works by deferring most of the tax liability to the late years of the bond's term.
Congressional sources said this would make them less attractive to most corporations because the companies would lose the accelerated deductions for repayment that they can now take. But it would not affect Occidental because, under other provisions of the law, it has no federal tax liability, they added.
Peter Goldsmith, manager of bond research at Merrill Lynch Pierce Fenner & Smith, and other Wall Street analysts said zero-coupon bonds are attractive to corporations because they provide quick cash infusions without the need to make periodic interest payments, and to tax-exempt investors because they lock in long-term high rates without the need to make reinvestment decisions as interest is received. If interest rates should rise again, however, the market value of the bonds, and their desirability as long-term holds, would drop accordingly, they said.