A Closer Look at Zero
ome bonds pay no interest but are offered at a substantial discount below their
par values and hence provide capital appreciation rather than interest income.
These securities are called
zero coupon bonds (
discount bonds (OIDs)
. Some corporations use these bonds to manage their matu-
rity structure. In addition, these bonds provide some desirable tax features for cor-
porations, as we discuss later in this extension.
Corporations first used zeros in a major way in 1981. IBM, Alcoa, JCPenney,
ITT, Cities Service, GMAC, Martin-Marietta, and many other companies have
used them to raise billions of dollars. Municipal governments also sell
Shortly after corporations began to issue zeros, investment bankers figured out a way
to create zeros from U.S. Treasury bonds, which were issued only in coupon form.
In 1983 Salomon Brothers bought $1 billion of 7%, 30-year Treasuries. Each bond
had 60 coupons worth $35 each, which represented the interest payments due every 6
months. Salomon then, in effect, clipped the coupons and placed them in 60 piles;
the last pile also contained the now
bond itself, which represented a prom-
ise of $1,000 in the year 2013. These 60 piles of U.S. Treasury promises were then
placed with the trust department of a bank and used as collateral for
U.S. Treasury Trust Certificates,
which are, in essence, zero coupon Treasury
bonds. A pension fund that, in 1984, expected to need money in 2009 could have
bought 25-year certificates backed by the interest the Treasury will pay in 2009.
In 1985, the Treasury Department began allowing investors to strip long-term
U.S. Treasury bonds and directly register the newly created zero coupon bonds,
called STRIPs, with the Treasury Department. This bypasses the role formerly
played by investment banks. Now virtually all U.S. Treasury zeros are held in the
form of STRIPs. These STRIPs are, of course, safer than corporate zeros, so they
are very popular with pension fund managers.
To understand how zeros are used and analyzed, consider the zeros to be issued
by Vandenberg Corporation, a shopping center developer. Vandenberg is developing
a new shopping center in San Diego, California, and it needs $50 million. The com-
pany does not anticipate major cash flows from the project for about 5 years; how-
ever, Pieter Vandenberg, the president, plans to sell the center once it is fully
developed and rented, which should take about 5 years. Therefore, Vandenberg
wants to use a financing vehicle that will not require cash outflows for 5 years. He
has decided on a 5-year zero coupon bond issue, with each bond having a maturity
value of $1,000.
Vandenberg Corporation is an A-rated company, and A-rated zeros with 5-year
maturities yield 6% at this time. (5-year coupon bonds also yield 6%.) The company
is in the 40% federal-plus-state tax bracket. Pieter Vandenberg wants to know the