Q: In an interview in a recent issue of U.S. News and World Report, Peter Lynch (the portfolio manager of Fidelity Magellan Fund) was quoted as saying that he liked long-term corporate bonds because "at 12 percent you make fourfold on your money in 12 years." The arithmetic, in round figures, is correct -- providing you can find a corporate bond where interest earnings also could be reinvested at 12 percent. Does he know something the public doesn't know? I've never heard of a bond that performed that way.
A: A couple of years ago, I met Peter Lynch briefly during a visit to Boston, and was impressed by his knowledge of the investment business. And, of course, it's difficult to argue with the performance of his Magellan Fund, which for some time has led all similar funds in performance during the preceding five-year period.
However, the problem you found with his statement is a valid one. The double-doubling of your principal in 12 years holds only if the interest is compounded at the initial rate. You're not going to get there if you are forced to invest the semi-annual interest checks at about 7 percent, today's money market yield.
But there are corporate bonds that make just such initial-rate compounding possible: zero coupons. You buy a zero coupon at a substantial discount from face value; the purchase price takes into account the stated yield compounded over the life of the bond.
Of course, there are disadvantages to zeros, as there are with any other investment: You get no cash until maturity, but must report and pay income tax on the accruing interest each year. But the zero is a corporate bond that lets you lock in the original stated yield both for the invested principal and for compounding of the semi-annual interest as it accrues.
Q: I am at a loss to understand a statement in your Sept. 16 column on the utility-dividend reinvestment program. Talking about the one-year holding period for long-term capital-gains treatment, you said that sale of any of the shares -- either the original shares or the shares in the reinvestment program -- "would cost you the favored tax treatment." By "any of your shares," do you mean that those tax-deferred reinvestment shares that are now more than a year old may not be sold for a long-term gain? With regard to "the original shares," am I to interpret that those shares already owned when the tax-deferral program began in 1982 -- and which are certainly now more than a year old -- may not be sold for a long-term transaction? My comprehension of your article leads me to disagree; I suggest that you may wish to clarify what you really intended to convey.
A: What I said is what I really intended to convey; and your interpretation of what I said is correct. If you sell any of the shares of that particular utility stock before the expiration of a year and a day from the date of the last tax-favored dividend, you will lose the favorable tax treatment and will have to report all dividend shares owned for a year or less as ordinary income.
Of course, you won't lose the long-term treatment of the original shares when they are sold. But you may not sell those original shares while retaining the tax-deferred shares (from the reinvestment plan) without losing the special tax treatment on those reinvestment shares.
The IRS puts it this way: "If you dispose of any common stock of the distributing utility one year after the qualified common stock dividend date, you will be treated as selling the stock received as a qualified stock dividend to the extent of the shares of qualified common stock received as a dividend." (Publication 550)
So if you want to take advantage of the special tax treatment offered the shares purchased through a dividend reinvestment plan (i.e., long-term capital gain over a cost basis of zero), you will have to hold all the shares -- the original shares plus those accumulated through the reinvestment program -- for at least a year and a day after the last reinvestment-dividend date.
Incidentally, you may not have to wait for the Jan. 1, 1987, date I cited. If, for example, the last tax-deferred dividend was paid as of Nov. 15, 1985, you need only wait until Nov. 16, 1986 -- a year and a day after the last dividend. I used Jan. 1, 1987, as a date that would cover all posibilities.