NATIONAL ASSOCIATION OF BOND LAWYERS
Voice from the Past
Chapter 18
At a closing in New York, some time in the late 1970's, I
was told of a new device in
municipal bond issues: one or more maturities of an issue bear no
current interest but are sold
at a discount that produces a significant yield on redemption at
par when due. My informant,
a bond dealer, was excited because the bond was so well received
by the market; it sold
bearing a modest fraction of the yield on ordinary bonds that
paid interest every six months.
He predicted, correctly, that as soon as this device caught on,
zero coupon bonds would be
sold in such numbers that their yield would soon rise to
approximately that of conventional
bonds.
A few months later I was asked to prepare documents for an issue
that included such
bonds in the final maturities. I asked why only those
maturities, and was told that this was
what the numbers people ordered. Why the numbers people chose
only those maturities was
a mystery, like so many of their demands.
This was in the days after the introduction of personal
computers but before
spreadsheets. To persuade a computer to be of any help you had
to write a program for it. I
had learned to write BASIC programs, and decided to see how much
difference it made in the
amount of money required to pay a bond issue of the same yield to
maturity if zero coupon
bonds were included in various different maturities. Assuming
that the annual payments of
principal and interest combined were the same to the nearest
$5,000 or so, it turned out that
including such bonds in the last maturities did in fact reduce
the cost of repaying the issue.
On the other hand, if the zero coupon bonds fell due in the
earlier years, it would take more
money to pay the bond issue. This experience left me wondering
about the fickleness of
mathematics.
Eventually someone pointed out that because, under normal yield
curves the late
maturing bonds of an issue bear interest at a higher rate than
the early maturities, eliminating
the payments of relatively high-rate interest from the early
years makes more money available
to pay principal in these years. This shortens the average life
of the issue and allows a greater
proportion of the issue to comprise shorter, lower rate bonds. At
first this sounded to me
more like a rationale than a reason, but when I ran the numbers
on various hypothetical bond
issues, it turned out to be correct. This feature might come in
useful when necessary to keep
the average life of the issue within some limit imposed by law,
regulation, or documents
governing prior issues. I never had to face the question of how
zero-coupon bonds would be
treated for State debt limit or election requirement purposes.
Since the amount of money
actually borrowed at the time of issue of such a bond is
relatively small, the initial value of
the bond might put the issue within the limit on the date of
delivery; yet if no bonds are
retired in the next few months, an excess of debt might result
from the increase of the
principal amount of the bond every six months by the amount of
accrued interest.
Alternatively, if the amount of the debt is determined only at
delivery, and if the issue
containing the zero coupon bonds is then within the limit, the
increase might use up future
debt incurring capacity under a constitutional or statutory debt
limit. It might also be that, if
the voters authorize only the initially issued amount, the
transubstantiation of interest into
principal violates the election requirement.
The 1980's became a time of very high interest rates. The
psychology of investors
was bemusing because some considered that this was an excellent
time to buy long-term
investments; yet others felt that they should not invest long
because rates might go even
higher. In the case of zero coupon bonds, the effect of a change
in market interest rate makes
much more of a difference in price than when current interest
bonds are involved; and this
effect increases with the length of the maturity. So what now
seems a sure way to have
gotten rich looked too risky to some. As tax exempt rates
exceeded ten per cent per annum,
this latter group were guided more and more by fear that rates
would keep on going up.
However, there were investors willing to take that chance with
some of their money. I
know of one who paid about $28,000 for the entire final maturity
of a 32-year issue of single
family mortgage revenue bonds. It comprised a zero-coupon bond
in the face amount of
$1,000,000, yielding 11.559%. Needless to say, it was subject to
early call for redemption,
and that call was exercised, bit by bit over the years, until
nothing was left. Yet it was a
good ride as long as it lasted. This points out another
advantage to the issuer of zero coupon
bonds in those cases (such as single family mortgage revenue
bonds) where there will
probably, but not certainly, be a lot of money (such as from the
prepayment of mortgages)
available to redeem bonds prior to maturity: the greatest future
liabilities can be reduced at
particularly great advantage when the compounding effect is
terminated early.
The market for zero coupon bonds was not limited to those issued
by States and local
governments. Salomon Brothers and Merrill Lynch came to market
with CATS and TIGRS.
Each such obligation comprises a right to payment from the
proceeds of a certain future
installment of interest on, or principal of, a government bond
held in trust. They sold well
enough so that the U.S. Treasury decided to get into the
business, too, with STRIPS.
Anyone who has tried to determine which SLGS (State and Local
Series Government
obligations) would best fill an advance refunding escrow, with
its fixed demand for payments
of principal of and interest on refunded bonds, knows how
awkward, and often inefficient, it
is. Consider trying to fit hexagonal pegs into octagonal holes.
At one time, when Treasury -
IRS proposed regulations governing SLGS, I suggested that they
ought to be issuable as zero
coupon obligations; this would eliminate the problem of having to
keep interest received on
SLGS lying around unused for months, and would make filling the
escrow almost trivial;
whoever was assembling the SLGS would simply buy a SLG for each
payment out of the
escrow at whatever available discount was convenient, so long as
the yield on the entire
package of SLGS did not exceed the yield limit. The idea got
nowhere.
One feature of zero coupon municipal bonds has puzzled me: their
treatment for State
income tax purposes. In general, States base taxable income for
State purposes on Federal
taxable income with adjustments, including the addition of
interest on municipal bonds not
exempt under State law. It is clear that interest on zero yield
corporate bonds is Federally
taxable as it accrues from year to year, and not entirely when
paid at maturity. So, by
analogy, one would think that accruals of interest on zero coupon
municipal bonds would be
taxable by the States from year to year in the amount of each
accrual. However, the accrual
concept for corporate bonds is specifically established by
Section 1272 of the Internal
Revenue Code. If State law declares municipal bond interest
taxable in the year received, and
does not cover accruals, the analogy (even though supported by
sound public policy) and the
law are at odds. I vaguely recall a common law doctrine to the
effect that if a person
voluntarily pays a tax under a mistaken interpretation of law, he
can't get it back. This
situation might make a good subject for someone who chooses to
write about the present,
rather than the past.
Manly W. Mumford