Maybe It’s Time to Drop a Few Zeros From Your Retirement Plan?
Back in the 1980s and early 1990s, a warm enthusiasm for zero-coupon bonds developed among long-term investors, such as pension and profit-sharing plans. “Zeros” are deeply discounted, non-interest-bearing bonds that accrete in value annually to equal their par or redemption value at maturity.
Zeros had (and still have) much appeal. If you had a relatively new plan with fewer dollars to invest, you could buy a lot of zeros at a very small cost and receive a sizable sum when they mature on a specific date in the future. Since the intention of a retirement investment plan is to grow capital, it was reassuring to know that the initial investment in zeros would remain intact and you could count on the amount of money you would have at retirement.
With zeros, you can match their maturities and amounts to meet known future liabilities, such as payouts to pensioners or specific annual payouts to yourself. Plus, you could ladder zeros at maturities to correspond with specific retirement dates and payout periods. However, you may want to look at the investments in your pension and profit-sharing plans and determine if you have too many zeros, thus unnecessarily dragging down your overall pension and profit-plan earnings. Because you aren’t earning “interest on interest,” you probably aren’t getting the highest yields you could from a variety of other zeros and interest-bearing bonds comparable in risk to your zeros. Let’s compare the non-interest-bearing zeros with other interest-bearing bonds.
When you buy a bond, the issuer is giving you a promissory note to repay a specific amount of principal to the note holder on a certain redemption date (the call date or the maturity date). On an interest-bearing note, the issuer agrees to pay in cash, usually semi-annually, the amount of interest that accrues on the note each year until it is redeemed.
With an interest-bearing bond, the interest can be reinvested, and you can earn “interest on interest.” Meanwhile, the original principal continues to collect interest at its stated yield. With zeros, a fixed accretion (growth) rate is locked in; you can’t enhance the bond’s earnings to anything greater than the accreted principal value. Because zeros pay no interest, you cannot earn “interest on interest.” (However, accreted interest income on these bonds may be subject to annual taxation as ordinary income even though no cash payments are received.)
You can advance yields by taking advantage of cycles in the interest rate market. Both U.S. Treasury strips (zero-coupon Treasuries) and long-term U.S. Treasury bonds (interest-bearing) are very liquid, and there is plenty of time between purchase and maturity for you to “play” the interest rate fluctuations with these easily marketable securities.
If interest rates fall, there is usually a big increase in the value of long-term bonds, and an opportunity to realize a capital gain if you sell. Because strips pay no interest over this long-term period, their price is more volatile than the interest-bearing bonds. If rates drop, strips will outperform bonds during this rate move. Of course, there’s a flip side. When rates move up, strips will greatly under perform interest-bearing bonds, not only because they are more volatile, but because the interest earned on higher interest-bearing bonds can be invested at increasingly higher rates, helping to offset adverse price moves of the original investment. Of course, with both types of bonds, you can simply hold on to the original investment and wait for the next interest rate cycle. During this “holding-on” period, the interest-bearing bond, but not the zero, will pay cash interest to investors while they wait.
We’ve focused primarily on boosting yields in pension and profit-sharing plans, but many individuals buy zeros to cover children’s college or to give them a down payment for their first home. Zeros used for these purposes, too, may be a mistake. Over the long term, historically, no financial instrument has grown more than equities. If you have, say, 10 years to invest, you may profit most by investing in high-grade, well-established blue chip stocks and reinvest the dividends and capital gains. Also, you can probably put away more money for your children in the form of equities than in the form of bonds before you hit the $1,900 mark of annual income that is tax-advantaged for children under 19 (or 24 if full-time student) according to current IRS rules. For instance, if a bond yields 5% annually, you can invest about $38,000 before reaching $1,900 of income. If a stock’s dividend yield is 3% annually, you can invest about $63,000 before reaching $1,900 of income. Remember, once your under-19-year-old investment income exceeds $1,900, taxes are paid on the excess income at the parents’ tax rate. (After the age of 19, or 24 if full-time student, children establish their own tax rate.)
I strongly advise having a significant amount of retirement and pension-plan investments in equities.
If you insist on owning zeros, consider those offering higher yields. Several yield a higher rate of return than U.S. strips. For example:
Government Trust Certificates
are guaranteed by the U.S. Defense Department and, like T-strips, carry the full faith and credit guarantee of the U.S. government as to the timely payment of principal and interest. However, these zeros yield 20 basis points more than the comparable term T-strip.
Government Agency Securities
historically have not carried the full faith and credit guarantee of the U.S. government. The agencies have a perceived tie to the federal government as institutions established under federal legislation, and thus have an implied AAA rating, but carry greater credit risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Finance Agency became the conservator of the two housing mortgage insurance agencies: FNMA and FHLMC. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies. From time to time some agency securities yield more than other “agencies” due to debt issuing schedule or other financial circumstances. Look for and take advantage of these potential opportunities. These may yield 15-25 basis points more than the comparable term Treasury.
are typically issued by quality corporations with high credit ratings. Historically, these have provided a rate advantage over both Treasuries and Agencies and are still very creditworthy.
are zeros issued by foreign governments or corporations but denominated in U.S. dollars. Some sovereign country Yankee Zeros are highly rated, provide more yield than Treasuries or Agencies, and are more creditworthy than corporate zeros. They maintain a higher yield than other comparably rated zeros in order to boost sales, since investors are not very familiar with them. So sit down with your portfolio and consider the merits of zeroing out some of your zeros!