Zingy Zeros

Wall Street's hot bonds

When cocktail-party chatter turns to investments these days, it frequently contains a new buzz word: zeros. Short for zero-coupon bonds, the term refers to certificates that pay no interest for a decade or more but then mature into whopping sums. In just 18 months since the bonds were introduced, Wall Street brokerage firms have sold more than $30 billion. Says Katherine Reed, a bond analyst for Drexel Burnham Lambert: "Zeros are really the rage."

The certificates offer several key attractions. Like U.S. Savings Bonds, zeros sell for less than their face value and are much cheaper than conventional bonds. For example, for $4,000 an investor can purchase a zero-coupon certificate that pays 11% interest and is guaranteed to mature to $100,000 in 30 years. Through compounding, the principal and interest grow into that amount over the life of the bond. By contrast, the interest on a coupon bond is periodically paid out rather than compounded, so the investment does not balloon in value.

Most zeros are virtually risk free because they are backed by U.S. Treasury notes. A broker creates zero bonds by first purchasing large blocks of the Government securities and then offering customers shares in the form of zeros. Consumers can generally invest for as little as $1,000; maturities of available bonds usually range from ten to 30 years.

W. Joseph Wilson, a managing director of Merrill Lynch, thought up the zero option one morning two years ago while taking a shower in his winter home on Florida's Marco Island. Says he: "It occurred to me as the water poured over my head." Returning to New York City, Wilson managed to convince his company that the idea, though untried, was not all wet.

Merrill Lynch offered the first couponless notes under the name Treasury Investment Growth Receipts (TIGRs) in August 1982. The copycats quickly followed. The same week Lehman Bros, marketed Lehman Investment Opportunity Notes (LIONS), and the next month Salomon Bros, offered its Certificate of Accrual on Treasury Securities (CATS).

Despite starting a whisker late, Salomon caught up fast. Of the $30 billion worth of zeros that have so far been sold, the big investment banker has moved about $12 billion. Merrill Lynch accounts for sales of $11 billion more of the securities, while such big brokerages as E.F.

Hutton and Dean Witter Reynolds have distributed most of the rest.

Although holders of zeros receive no cash until their bonds mature, they must still pay annual taxes as the principal and interest grow. Result: tax-exempt investors like pension funds have been the main buyers of the bonds. But consumers are also snapping them up for Individual Retirement Accounts, which allow savers to defer taxes annually on as much as $2,000 of income. With this year's deadline for tax filing approaching, many investors have been finding the bonds a good place to put their cash.

Zeros suit other kinds of long-term plans as well. Jay Goldinger, a Beverly Hills investment adviser, calls them "an excellent means to save for a child's college education." If the parents of a five-year-old were to invest $9,440 in a high-grade zero paying 11% interest, says Goldinger, they would have $40,000 by the time the child reached 18.

The popularity of zeros makes them a means of financing the federal deficit.

Says Arnold Kaufman, editor of the Outlook, a publication of Standard & Poor's:

"They're selling so fast that they're helping to support the Treasury market."

The certificates do have some disadvantages. They provide buyers with no annual income. Moreover, like all other long-term bonds, zeros expose owners to the chance that interest rates may rise before the investments mature. Holders needing to sell early could thus find that their zero bonds were worth less than investments with a higher yield.

Still, brokers see a profitable future for zeros. Wall Street expects sales of about $45 billion during the next year and a half. Wilson, meanwhile, says he is developing eight new ways to invest in the bonds. That could help make zero an even hotter number than it already is.