Zero-coupon Treasury bonds are such a favorite among conservative investors that I hate to raise any questions about them. They serve a variety of good purposes, and at a very small outlay of cash.
But there's evidence that you may not always be getting a good market price for the zeros you buy. Hidden brokerage fees are built into the price you pay; in some cases, the bonds may yield less than the broker told you when you bought.
Zeros are an invention of the '80s. You put a small amount of money down; every year, interest accrues to the bond and raises its value; you're paid face-value for the bond when it matures. For example, you might pay $107 for a Treasury bond that will pay $1,000 face value when it matures in 2005. That's an effective yield of 11.5 percent over 20 years. Zeros also exist for corporate and municipal bonds, and for mortgage-backed securities, but so far, Treasuries have been the most popular.
(Until recently, you could not actually buy the bond itself; you got a receipt entitling you to a share of the income and value of a Treasury bond held in escrow. But new rules by the U.S. Treasury now make it possible for you to hold a share of the bond directly.)
There's no magic to zeros, other than the magic of compound interest. You can get a similar interest rate from other bond investments. But zeros have a couple of advantages:
* You pay a small amount of money up-front, so you don't have to tie up a lot of cash currently.
* The yield-to-maturity on other bonds assumes that you'll always invest the interest income at the same rate paid by the underlying bond, which is not always possible. But with zeros, you are guaranteed a yield to maturity right from the start -- because all the interest payments are built right in.
A drawback is that the interest credited to your bond each year, but not paid out, is taxable currently. So if you hold a zero in the normal way, you'd be paying taxes on interest that you have not actually received in cash. To get around that problem, zeros are generally bought for tax-deferred retirement plans or for children whose tax bracket is nominal.
A risk is that you might have to sell before maturity. Zeros are more volatile than other bonds, so you might not get as good a price. These are bonds that should be held to the bitter end.
An even greater risk -- which is just now coming to light -- is that all brokers may not be figuring the yield in a straightforward or uniform way.
Take the class-action lawsuit recently brought by a group of Michigan investors against the brokerage firm Merrill Lynch. The investors' lawyer, Nelson Chase of West Bloomfield, Mich., says that when his clients bought the bonds in 1983, they were priced at 7 cents on the dollar. Just two weeks later, their value had unaccountably fallen to 5.4 cents on the dollar, a 22 percent loss. Nelson charges that the drop was the result, in good part, of a large and undisclosed markup on the bonds that profited the securities firm. (A Merrill Lynch broker told him, he says, that a lot of foreign investors had destabilized the market.)
"A yield of 11.95 percent for these zeros was quoted verbally to my clients," he told my associate, Virginia Wilson. "We figure that the net yield is only 9.7 percent." The confirmation slip from Merrill Lynch that documented the purchase did not disclose the net yield.
Nelson also says that Merrill Lynch failed to disclose that the bonds could be called earlier than the investors believed, and argues that zeros should be issued with a prospectus to compel disclosure. E. F. Hutton, the Michigan investors' new broker, handled the securities differently from Merrill Lynch, Chase says; the difference, he says, indicates that the investors overpaid.
Merrill Lynch denies the charges, including the accusation that there was an excessive markup.
The Securities and Exchange Commission is taking an interest in this case. Richard Ketchem, director of the SEC's division of market regulation, says that the net yield for zeros should be on the order's confirmation statement. Also, it should be the yield to the first date that the bond can be called in by the issuer, not the yield to maturity. "At minimum," he adds, "the SEC considers markups in excess of 10 percent to be fraudulent."
Investigations are in progress as to what constitutes a fair price for a zero-coupon bond. If you plan to buy, get prices from more than one brokerage house, because markups can be so different. And check your confirmation slip after the purchase, to see if the broker revealed the net yield -- and that the yield is the one you were promised when you bought.