If I want to invest in a zero-coupon bond for a short-term capital gain in a taxable account, would it be better to buy a 30-year or a five-year, considering that I would have to pay tax on the phantom interest? -- Ron Maltiel
If you're gunning for a short-term capital gain on a zero, you want the longest one you can get. Because the longer the bond, the more its price will rise if interest rates fall. Whether you're holding a five-year or a 30-year zero, a portion of any rise in price will represent income and a portion will represent capital gain. But since you're going to be taxed at your marginal income tax rate on both, you only care about the total -- and the total will be larger with the longer bond for the same change in interest rates.
Here's an example. A five-year Treasury zero, or STRIP (separate trading of interest and principal securities), maturing in May 2004 was recently priced 76.74 to yield 5.22%. A 28-year (good as a 30-year) STRIP maturing in November 2027 was priced 20.07 to yield 5.69%.
The duration of a zero-coupon bond (duration measures a bond's interest-rate sensitivity) is more or less equal to its maturity. The five-year STRIP's duration was 5.14 years; the long STRIP's was 28.64 years. Duration works in this way: If a bond has a duration of 5.14 years, then its price will rise 5.14% if its yield falls by 100 basis points and fall by 5.14% if its yield rises by 100 basis points.
So, suppose you are expecting a 25-basis-point drop in all interest rates. If you're holding the five-year STRIP and its yield drops to 4.97%, then its price will rise 0.97 to 77.91. That's a 1.26% price change, or a quarter of the change the bond would have experienced if rates had fallen by 100 basis points.
But if the long STRIP's yield drops 25 basis points to 5.44%, its price will rise 1.45 to 21.52, a 7.23% price change, or a quarter of the change it would have experienced in a 100-basis-point rally.
Suppose you sold at that point. Assuming your investments are Treasury
STRIPS in a taxable account (and please -- consult your accountant on this, since there are wrinkles everywhere) here's how your tax situation would work out, according to Richard Larkins, senior manager in
Washington national tax office.
A portion of your gain would represent income, and you'd report that portion as income. The remainder would represent capital gain. The income portion is figured by multiplying the yield at which you bought the instrument by your purchase price, and then multiplying the result by the fraction of a year you held it.
Say you held the five-year STRIP for a month. Of your $9.70 per bond gain, $3.30 would represent income (0.522 x 76.74 x 0.083) and $6.40 capital gain. If you held the long STRIP for a month, your $14.50 per bond gain would be 95 cents of income and $13.55 capital gain. But what matters isn't how your profit breaks down between income and capital gain. It's that the long STRIP rose more than the five-year.
Don't forget, though, that what goes around comes around. If interest rates rise instead of fall, the long zero's price will fall further than the five-year's.
One other point to consider: The prices I quoted are institutional prices. David Schroeder, who manages
Target Maturities funds, which invest mainly in Treasury STRIPS, says that when buying and selling lots smaller than $1 million of face value, you're going to pay retail markups when you buy and markdowns when you sell of at least a half-point. These will make it more difficult for you to realize a meaningful capital gain.
For example, suppose you paid 20.57 (a half-point markup) for the long STRIP. Your yield drops to 5.60%. Now, to realize the same price gain, factoring in the half-point markdown you'll receive when you sell, the yield has to drop by 33 basis points, not just 25. Especially in the short term, it may be more economical to buy zero-coupon fund shares. The funds charge an expense ratio that lowers your yield, but you get institutional pricing on the bonds. American Century runs the only long-maturity zero-coupon bond funds, and a recent
Fund Forum explained how they work.
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TSC Fund Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.