The investment firms that created the "felines" in the mid-'80s
did so by purchasing U.S. Treasury bonds and stripping the interest from the
principal. The interest payments were then divided into units, which
became the basis of zero coupon bonds.
For example, a firm might purchase a 20-year Treasury bond, which
it would place in escrow. It would then strip the interest from the
principal and divide it up into 40 units based on the semi-annual interest
payments of the Treasury bond. It could then issue 40 zero-coupon bonds,
each with a face value that equaled the interest payment on which it was
based. The zeroes would be sold at deep discount: A 20-year
bond that paid $1,000 at maturity might cost about $300.
These
Treasury-backed zeros offered investors a financial instrument that had abundant
supply, no default risk and, best of all, no chance of being called—paid
off before maturity, reducing the investor's return.
What makes the felines so popular with investors? We
will explore a few of the reasons next.
