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How to Calculate Your Basis in Target Maturity Fund Shares

Thank you for the article on the zero-coupon fund. I've owned (BTTTX) American Century Target Maturities Trust 2020 for five years and I recently sold some shares. Do I recalculate the cost basis for each year I've owned the shares? Your explanation covered only one year. Could you give an example of a multiple-year calculation?

-- Brian Bliss

Brian,

Sure, no problem.

First, let's briefly review how the American Century target maturity bond funds work.

Target maturity funds are designed to act like zero-coupon bonds. Unlike a regular bond , a zero-coupon bond doesn't pay interest income. So instead of being issued at a price close to face value, it is issued at a price far below face value and, ideally, the bond's price gradually rises over the years toward face value. The interest rate, or yield , that the investor gets is a function of the difference between the price paid for the instrument, its face value and the time remaining till maturity.

Target maturity funds are designed to mimic the performance of a zero-coupon Treasury bond that matures in the year stated by the fund. Like zero-coupon bonds, zero-coupon fund shares gradually appreciate toward a target level, usually $100 a share. The 2020 fund, for example, was first offered to investors in December 1989 at $12 a share, and closed last night at $34.10. By 2020, when the fund will distribute its assets and cease to exist, American Century aims (but does not promise) to give investors $100 a share. The pace of the appreciation depends on the performance of the bond market.

Unfortunately, how it gets to its target price is quite complicated. A zero-coupon bond doesn't pay any interest income, but a target maturity fund is required by the Internal Revenue Service to distribute its imputed interest. Imputed interest is the portion of the difference between the purchase price and the target value at maturity that accrues each year.

But clearly, a zero-coupon fund that is distributing imputed interest each year won't ever reach its target price, since a mutual fund's share price decreases by the amount that it distributes.

To get around this problem, a target maturity fund performs a reverse share split when it makes distributions. The reverse share split allows the funds to maintain their predistribution price.

For example, say you owned 100 shares of the 2020 fund last Dec. 10, when the fund made its annual distribution of $5.15. The predistribution share price was $31.41.

So you had 100 shares at $31.41. You received a distribution of $515. If you reinvested the distribution, it went to purchase an additional 20 shares (rounded) at the postdistribution price of $26.27 (the predistribution price of $31.41 minus the $5.15 distribution). Then, in the next instant, a reverse share split was performed. The total number of shares was multiplied by a reverse share split factor, calculated by dividing the postdistribution price by the predistribution price. In this case, it was 0.83 (26.27 divided by 31.41).

So your 120 shares at $26.27 would become 100 shares at $31.41, as follows:

120 x 0.83 = 100

Had you taken your distribution rather than reinvesting it, the reverse share split would have left you with 83 shares.

Your question concerns how your tax basis in your shares is affected by all this. It's actually pretty simple. Each time the reverse share split is performed, you adjust your basis upward by dividing it by the reverse share split factor. Let's work through an example.

Say you bought 100 shares of 2020 in 1998 at $33 a share.

On Dec. 11, 1998, you would have received a distribution of $7.27 a share. If you reinvested it, the $727 distribution would have bought you 25 additional shares at the postdistribution price of $28.85. Then the reverse split would have returned your share balance to 100 shares at the predistribution price of $36.11.

The 100 shares you owned initially now equate to 80 shares: 100 times the reverse share split factor of 0.80 (28.85 divided by 36.11). Your basis in those shares becomes $41.25. Remember, you divide your original basis by the reverse share split factor.

$33 / 0.80 = $41.25

The 25 shares your distribution purchased now equate to 20 shares, and your basis in them goes from $28.85 to $36.06.

$28.85 / 0.80 = $36.06

That brings us back to our original example. If you still held the 100 shares on Dec. 10, 1999, you would have received a $515 distribution, which would have purchased an additional 20 shares at $26.27. After the reverse split, you would have 100 shares at $31.41.

You would recalculate your bases as follows:

You had 80 shares at a basis of $41.25. They now equate to 66.4 shares at $49.70.

$41.25 / 0.83 = $49.70

You had 20 shares at a basis of $36.06. They now equate to 16.6 shares at $43.45.

$36.06 / 0.83 = $43.45

You bought 20 additional shares at $26.27. After the reverse split, they equate to 16.6 shares at $31.65.

$26.27 / 0.83 = $31.65

And so on. And so on. And so on.


Send your questions and comments to fixed-incomeforum@thestreet.com , and please include your full name. Fixed-Income Forum appears each Friday.

TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.

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