Beware the zero-interest-bond promotions. I'm not speaking here of bonds as investments. My subjects are the "free" or "bonus" bonds now being offered by a wide range of salesmen -- from homebuilders to car dealers -- to tempt you into buying their products.
The Better Business Bureau warns that these kinds of sales campaigns are often misleading. You're rarely given the facts you need to evaluate the bonds, and may be lulled into paying too much for the products they're tied to.
Zeros work like U.S. Savings bonds. Buyers pay only a small fraction of the investment's face value. You receive no interest payments currently (that's why the bonds are called zeros). Instead, each year's interest accumulates within the bond. Over the years, the value gradually builds. But not until it reaches maturity can you collect the bond's face value.
Here's what makes zeros so alluring to salesmen without shame: For a very small outlay of cash, they can make unsophisticated customers believe that they are getting a very large gift.
Take, for example, the New York car dealer, who offered a "free" $5,000 zero bond to people who bought new automobiles. It sounds like an extraordinary offer -- one that effectively halves the cost of the purchase. But it would have taken 30 years for that bond to be worth $5,000 (something that wasn't disclosed). Its current value was only $150 to $160 -- and that price was almost certainly covered by the price that the dealer charged for the car.
Or take the homebuilders who advertise "money back" homes. Each sale is packaged with a zero bond, whose face value equals the price of the house. Are buyers really getting a free house? No, indeed. A 30-year, $70,000 zero might cost only $2,400 today -- and you can be sure that that cost is buried in the price of the home. If you sell the bond before 30 years are up, you will get much less than its face value.
Zero-bond promotions also have been tied to the sale of furniture, and to the granting of loans. In the latter case, loan companies require applicants to buy zero bonds as collateral for the money they get -- and the lenders then overcharge their customers for the bonds.
A recent survey, by the Better Business Bureau and the North American Securities Administrators Association, found questionable zero-based sales schemes in 30 states. Several states now ban or restrict their use in hyping retail sales.
Zeros do more than confuse customers. They can create unexpected costs.
One surprise is the tax cost. Although the interest on zeros is paid in the form of the bond's annual increase in value, it is nevertheless considered taxable income every year. So you may have to pay taxes on money you have not actually received in cash. Few salesmen explain this, when handing you a "free" zero.
Some zero bonds are made from tax-free municipals, in which case no annual taxes may be due. But most of the zeros are built from taxable U.S. Treasury issues.
Another surprise, if your zero is linked to a house you buy, may be the limited size of the mortgage you can get. The FHA has ordered its lenders to subtract the cost of the zero bond from the house price, and grant a mortgage only on the value that remains. That means a smaller loan and a larger down payment.
Yet another surprise, to many buyers, is how little you can get from the bond if you sell fairly soon. If you cash in your $5,000 zero after, say, three years, you might get $200 or less. That's hardly the "money back" investment that might have induced you to buy the car or the furniture in the first place.
The price you can get for your zero bonds should you decide to sell varies as interest rates change. If interest rates rise, the value of your bond will fall much more than other bonds, because zeros are particularly susceptible to market changes. You need a good market to realize the bond's apparent worth.
Some buyers might say, "So what? It's still a free bond, and a freebie is better than nothing." But it isn't free.
You probably paid $150 more than necessary to buy, say, the car -- just to get a "free" $5,000 zero. If you bail out, you'll likely get a poor price (because just one small bond is hard to sell), and you'll have to pay brokerage charges on the transaction.
If you sell within two or three years, you could easily wind up with less than $150 for the bond -- in which case, your "free" bond will have cost you money.