Evaluating zero-coupon bonds. (Finance)

EVALUATING ZERO-COUPON BONDS

Under the new tax laws, some kinds of investments have become considerably more attractive. Because of the sweeping changes in tax reform, income-oriented investments are in, while tax shelters and fast-growth investments are out. Why? Because preferential treatment for capital gains is a thing of the past. Therefore, in-the-hand income is worth a lot of in-the-bush market appreciation.

Zero-coupon bonds drew quite a bit of attention when they were introduced just a few years ago because you don't need a great deal of money to start buying them, they have good yields, and they can appreciate substantially. Zero-coupon bonds differ from conventional bonds in that they do not pay interest until the bond matures. Historically, these bonds have been a favorite investment for Individual Retirement Accounts (IRAs) and trust funds, where there can be preferential tax treatment. Zero coupons are still good investments for these purposes, but given the new tax laws, you can also consider them for non-tax-preferred investments. They provide a stable rate of return, long-term placement, and with the additional dimension of bond valuation, a "pure" interest-rate play for those who want to take the money and run.

A short recap of basic bond mathematics will help make this point. Bonds pay interest (the yield) on a specified capital, or par amount. Thus, a $1,000 par-value bond that yields 8% will pay $80 per year in interest. At the bond's maturity, which can be as far away as 30 years, the bondholder will also receive the par value back in one lump sum. Bond interest is usually paid semiannually, and bond yield calculations assume that you will be able to reinvest the cash flow at the same rate as the bond. In the real world this seldom happens because interest rates fluctuate. If the rates go up, you can earn more on your reinvestment of the interest than you are earning on the bond that provides it. If rates go down, the reverse will be true.

Apart from their not paying interest until maturity, zero-coupon bonds follow all the rules of conventional bonds. Because of this unique feature, zero-coupon bonds are also called deep-discount bonds. This peculiarity affects the way they are priced. To understand this, let's compare them to a conventional bond to highlight the differences.

Assume that the 8%, $1,000 bond we discussed earlier matures 10 years from today. If the …