A new tax-free instrument that in effect represents new investment technology has appeared in the market. Whether it is here to stay remains to be seen, but some comments are appropriate. The basic type of municipal bond is a coupon bond, which pays interest twice a year and returns the principal at maturity. It is exempt from federal taxes and state, and usually local, taxes by the state in which it was issued.
There are also zero coupon bonds, which are sold at prices discounted below par value (i.e., 5 cents to 60 cents on the dollar) and which pay no current income. The investor receives a lump-sum payment at maturity made up of the original cost plus the accreted compound interest. The appeal of zeroes is that the stated purchase yield is the actual yield you receive over the life of the bond. You do not have to reinvest income -- it is all done for you in zeroes -- whereas with a coupon bond the investor must reinvest the semiannual coupons at the stated purchase yield to maturity to really obtain that true yield to maturity. The accreted income on the zero is tax-exempt, similar to the coupon situation.
The new securities are called GAINS (Growth and Income Securities) and combine the coupon form with the zero coupon form. Initially, GAINS are structured as zeroes for 10 to 12 years. When their value reaches par (in 10 to 12 years, known as the crossover date), they assume a regular coupon at the original offering yield and commence to pay semiannual interest to maturity or their retirement date. An example should clarify the situation.
Recently, a Maryland Health and Higher Education revenue issued was sold for Johns Hopkins University. The issue was rated AA by Moodys and AA by Standard and Poors. Some of the individual maturities were as follows:
*8.70 percent due July 1, 1997, offered at $1,000 to yield 8.70.
*GAINS: 0 percent due July 1, 2007, with a crossover date of July 1, 1997, offered at 9.75 percent -- the initial offering price was 32.45, or $324.50 per $1,000 bond;
*A 9 percent bond due July 1, 2005, offered at $990, to yield 9.10 percent.
In comparing these various segments of this same Johns Hopkins issue, we note that the yield to 1997 on the GAINS portion is 9.75 percent, while on the current coupon portion to 1997, the yield is 8.70 percent, an advantage of 105 basis points in favor of the GAINS. On July 1, 1997, the crossover date, the GAINS segment (in theory, now at par) assumes a 9.75 percent coupon and will pay interest semiannually until 2007, or until the issue is redeemed prior to 2007. Here we see that the GAINS still is returning 9.75 percent to 2007, while the current coupon's 9 percent maturity in 2005 is yielding 9.107 percent. Because of the higher return on the GAINS after the crossover date, until maturity, call protection becomes important. The longer the call feature (3 to 4 years) and the higher the call price ($1,020-$1,040) the better. Another consideration is that, when the crossover date is reached, interest rates could be 11 percent, which would mean the GAINS would be selling below par ($1,000).
GAINS are not for all investors. Because you end up getting your cash income in 10 to 12 years, it would fit an investor with high income or one who would need tax-exempt income around the "crossover date." It is also good to consider that, when the cash income payments begin, if the investor had invested only $324.50 and now was beginning to receive $97.50 a year per $1,000 bond, the rate of tax-free return on the original investment is 30 percent (97.50-24.50).
The name GAINS is proprietary to Goldman Sachs. Other names for GAINS and their issuers are: FIGS, Paine Webber; NACS, John Nuveen; PACS, Smith Barney; CCAPS, Shearson Lehman; and Tax Deferred Interest Securities, Kidder Peabody.